Options trading involves a few key terms that traders must understand before starting trading. Understanding them is essential as it helps traders form realistic expectations, set appropriate goals, and manage risks. These terms include but are not limited to ‘premium’, ‘strike price’, ‘expiry date’ and ‘margin requirements’.
The premium is the option’s current market price. It is paid by the buyer to the seller (or ‘writer’) when the trade is entered, and is non-refundable. The premium is determined by several factors, including the underlying asset price, strike price, volatility, time to expiry and interest rates.
The strike price is the level at which the holder of the option can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset. The strike price is not necessarilyequal to the current market price of the underlying asset, but is set at a predefined level at the start of the contract.
The expiry date is the date on which the option expires. At expiry, the option will be worth nothing (if it is out-of-the-money), otherwise you will exercise it, and the underlying asset will be bought or sold at the strike price.
Margin requirements are the amount of money the buyer must deposit to open a position. In options trading, margin requirements are generally much lower than for other types of trading, such as stock trading. Only a small percentage of the overall value of the trade is normally placed as collateral. For unhedged options positions, this can become an enormous risk.
Put/call parity is an essential concept in options trading. It refers to the relationship between the price of a put option and the price of a call option with the same strike price and expiry date. Put/call parity ensures that the two options are priced equally.
Delta is a measure of how much the price of an option changes relative to changes in the underlying asset price. Delta can be positive or negative, but it is always between 0 and 1. A call option with a delta of 0.5 will increase value by $0.50 for every $1 increase in the underlying asset price.
Gamma measures the extent of change in the delta of an option concerning changes in the underlying asset price. Gamma is always positive, which means that the delta of a call option will always increase as the underlying asset price increases.
Theta measures how much the value of an option decreases over time. Theta is always negative, which means that options lose value as they approach expiry. There is less time for the primary asset price to move enough to make the option profitable.
Vega measures how much the value of an option changes concerning changes in volatility. Vega is always positive, which means that options increase in value when volatility increases. A higher volatility means a greater chance of the option expiring profitable.
Rho measures the extent to a change of the value of an option concerning changes in interest rates. Rho is always positive for call options and negative for put options. The higher the interest rates are, the more expensive it is to buy the underlying asset, making call options less valuable. Conversely, higher interest rates make it cheaper to sell the underlying asset, making put options more valuable.
Open interest is the amount of outstanding options contracts for a particular security. Open interest increases when new options are created and decreases when options are exercised or expire. High open interest means a lot of activity in the options market for a particular security.
Liquidity refers to how easy it is to buy or sell an asset. Highly liquid assets can be bought or sold quickly and at low costs. Highly liquid options have high volumes of trading activity and tight bid-ask spreads. Less liquid options may be more challenging to trade and broader bid-ask spreads. Check out this site for more information on options trading.