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Basic Terminology Involved in Options Trading


Options Terminology
Options, as we have described in option basic sections, is a contract entered by two parties (a buyer and a seller) which specifies price of financial instrument with time validity. The party which buys option is called holder and the party which sells option is called option writer. Options holder has right to buy at any time on or before expiry date but is not bound by contract to buy it by paying premium to option writer.

Going little deeper in all the important terms used in options:
1. Strike price: Strike price is price at which contract between buyer and seller is agreed for a financial instrument with time validity. The party which buys option is called holder and the party which sells option is called option writer.
For Call option, it is the price at which the call option buyer can buy the stock. For Put option, it is the price at which the put option buyer can sell the stocks.

2. Option Exercise: Options are exercised when the holder of the option is in the money(making profit) and actually wants to complete the option contract. In case of call option, option buyer will exercise option when the price of underlier (Stocks) is above strike price by buying the underlier and in case of put option buyer will exercise option when the price of stock is below strike price by selling the underlier.
Please note that all options are not exercised. If the buyer is not in profit they may not exercise the option.
When the buyer is in profit, then they may either exercise option or may trade to earn profit.

Depending on type of options, exercise methods may differ. They are:
a.American Style Options: In this kind of option, option exercise can happen on any day on or before expiry date.
b.European Style Options: In this kind of option, exercise can happen only on expiry date.
c.Bermudan Style Options. In this option, exercise can happen only n specified dates.

3.Premium: It is the amount the option buyer pays to option seller(writer) during entering the option contract. Maximum loss to the buyer is the premium while maximum profit for the buyer is unlimited. Maximum profit for the seller is the premium (fees) to take the risk.
Option premium depends on various factors like Stock price, strike price, expiry date and stock volatility etc.
More explanation coming in few days.

4. Option Expiry date: It is the date upto which option contract is valid. Any time within options contract period buyer can exercise option.

5. Underlying Security: Options are derivatives. They derive the value from the underlier (Stock). Price of option (premium) fluctuates with the change of price of underlier. If the underlier is volatile, premium is higher.

6. Option Holder: Buyer of option is called option holder.

7. Option writer: Seller of option is called option writer.

8. Lot size

9. Open Interest

10. Implied Volatility

Note :We have kept these definition as very simple and added most basic ones. We will have full fledged explanation in subsequent tutorials.

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