Options

 An option is defined as a type of contract, sold by one party to another that gives the buyer of the option, the right, but not the obligation to buy or to sell the underlying stock at a pre-determined price.

Options cannot exist indefinitely and every option has an Expiry Date.

Strike Price - Every options contract will have an associated strike-price. This is the fixed reference price against which settlement takes place at the time the option is exercised or when the option expires.

Lot Size - It specifies the fixed number of units of the underlying security that one options contract covers. The lot size is usually determined by the regulatory body and varies from stock to stock.

Premium - It is simply the amount of money an option buyer pays per share when buying an option. It is dependent on various parameters called Option Greeks.

Call options - These options give the buyer the right to buy the underlying security at a fixed price.

Put options - These options give the buyer the right to sell the underlying security at a fixed price.

European Style Expiry - Denoted by CE and PE. In this style of expiry, options can be exercised only at the specified time of expiry.

American Style Expiry - Denoted by CA and PA. In this style of expiry, options can be exercised at any time till the specified time of expiry.

Volatility - It can either be measured by using the standard deviation or variance between returns from that same security or market index. The higher the volatility, the riskier the security.

1. Historical Volatility - It is the rate at which the price of the asset has changed in the past. Usually calculated for the past year.
2. Implied Volatility - Commonly referred to as IV, is the volatility exhibited by any particular option at present and reflects the short-term outlook an investor has on the underlying stock. It is calculated by the Black-Scholes formula.

Stock markets react negatively to uncertainty (high volatility) and will fall and will rise when there is less uncertainty (low volatility).

Option Greeks - There are primarily 5 underlying factors that determine the price of an option. These factors are collectively called the option greeks because each of these is named after a Greek letter.

1. DELTA - It signifies the rate of change of an option's premium based on the directional movement of the underlying security. A change in the underlying security causes every option associated with that to increase or decrease. The value of the delta ranges from 0 to 1 for call options and from 0 to -1 for put options. If a call option has a delta of 0.5, this indirectly implies this call option has a 50% probability of ending ITM by the time of expiry.
2. GAMMA - It is the rate of change of delta resulting from a change in the price of the underlying security. When evaluating two options exhibiting the same delta value, the one with greater gamma will have a higher risk.
3. VEGA - It expresses the change in the price of the option for one percentage of change in the underlying security's volatility.
4. THETA - It is the measure of an option's time-decay and it indicates the rate at which an option loses its time-value as it approaches its expiration date. Theta values are always negative for a buyer. At the time of expiry, the time-value of any option will reduce to zero.
5. RHO - It measures the sensitivity of an option to changes in the interest rate. It is the expected change in an option's price for a 1% change in the Reserve Bank's Treasury bill rate. Rho is the most predictable since the interest rates stay the same for a relatively long period.