Option Basics - III

Anup Menon

Last week we saw what is meant by American and European options. We also discussed volatility, which is one of the key factors in valuation of options. This week we shall see some more key terms in options.

Expiration Date: Options quoted in exchange include the date and the month on which the option can be exercised. This is called the expiration date. In the case of the European option, the investor can exercise his right on the specified `expiration date' only. In the case of an American Option, investors can exercise the option on or before the `expiration date'.

Strike Price: The `strike price' is the price at which an option can be exercised. For instance, assume that you hold an European Option on XYZ company for one share. The strike price is fixed at Rs 5,000 and the expiration date is 15th June 2001. If the prevailing market price is say Rs 5,500, then you can exercise your option on the 15th and buy one share of XYZ for Rs 5,000.

In-the-money options: Those options which are trading in positive territory are called in-the-money options. This means that in the event of exercising the option, it leads to a gain for the investor. For instance, in the example given above, if the stock was trading at Rs 5,400 on 13th June, then the option is in-the-money from the point of view of the holder.

Out-of-the-money options: Those options which give a negative cash flow to the investors are classified as out-of-the-money options. For instance, in the above example, if the price of XYZ on 13th June was Rs 4,500, then it would have generated a negative cash flow if exercised. Hence the option is classified as out-of-the-money.

At-the-money options: Those options which do not result in any cash flow, in other words, which result in zero cash flow for the investors are called At-the-money options. For instance, in the same example as described above is the price of XYZ was Rs 5,000 on 13th June, then the option is at-the-money.

Next week we shall look into some of the properties of the factors affecting valuation of options.