Understanding Options: Definition and Fundamental Concepts

Types of Options:

1. Call Options: These give the holder the right to buy the underlying asset. Traders purchase call options when they anticipate that the asset's price will increase.
2. Put Options: These grant the holder the right to sell the underlying asset. Put options are typically bought when there's an expectation that the asset's price will decline.

Key Attributes of Options:

• Derivative Nature: Options are derivatives, meaning their value is based on the value of another asset, such as stocks, bonds, or commodities.
• Expiry Date: Every option has an expiration date, after which it becomes void if not exercised.
• Exercise Styles: American options can be exercised any time before they expire, whereas European options can only be exercised at expiration.

Trading and Pricing Options:

• Trading Venues: Options can be traded on regulated exchanges or over-the-counter (OTC). Exchange-traded options have standardised contracts, while OTC options can be customised.
• Strike Price: This is the agreed-upon price for buying or selling the underlying asset if the option is exercised.
• Option Premium: This is the price paid to acquire the option, consisting of intrinsic value and time value. The intrinsic value is the difference between the current price of the underlying asset and the strike price. Time value reflects the potential for the option to gain in value before expiration.

Market Value Influences:

• In the Money: Options are "in the money" if exercising them would be profitable given the current price of the underlying asset. For call options, this means the strike price is below the asset's current price. For put options, it's the opposite.
• At the Money and Out of the Money: "At the money" options have a strike price close to the current asset price. "Out of the money" options would not lead to a profitable exercise and thus their intrinsic value is zero.

The Impact of Time and Volatility:

• Time Decay: Options lose value as they approach their expiration date, a phenomenon known as time decay.
• Volatility: Higher volatility increases the time value of options because there is a greater chance that the price will move favorably before expiration.

T

he Greeks - Measuring Sensitivity:

• Delta: Measures how much an option's price is expected to move per a one-unit change in the price of the underlying asset.
• Gamma: Indicates how much delta will change with a one-unit change in the underlying asset.
• Theta: Shows how much an option's price will decrease as the expiration date approaches.
• Vega: Measures sensitivity to volatility; a higher vega means the option's price is more sensitive to changes in volatility.
• Rho: Reflects how much the price of an option is expected to change per a one-percent change in interest rates