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Basic Options Terminology & Guidelines
The option type indicates the action one needs to take when exercising the option. A call option gives you the right to buy the underlying asset in the future, whereas a put option gives you the right to sell an asset in the future at a predetermined price.
Strike price is the target price set on the option. For call options, it is the price at which you can purchase the underlying asset for in the future. For put options, it is the price you can sell an asset for in the future.
The expiration is the date your option will stay active until. Once an option expires, it won't be exercisable, thus, will lose its benefits.
Premium is the price that a trader pays to purchase an option. It varies based on other option components like type, strike price, expiration, and volatility of the underlying asset.
A premium of an option will be higher if the underlying asset price is more likely to be equal to the strike price until expiration. The following conditions will increase the premium price of an option:
- Expiration is further into the future
- Higher difference between the strike price and the current floor price
- For Calls, premiums will be higher for lower strike prices
- For Puts, premiums will be higher for higher strike prices
- More volatile collections will have higher premiums for their options. As the price is more volatile, it is more likely that the options will be in the money.
An in-the-money option is when the floor price of the asset hits and goes over the strike price.
- For Call options to be ITM, the floor price needs to be higher than the strike price.
- For Put options to be ITM, the floor price needs to be lower than the strike price.
An out-of-the-money option is when the floor price of the asset hasn't hit the strike price yet.
- OTM Call options are when the floor price is less than the strike price
- OTM Put options are when the floor price is more than the strike price
The breakeven price is the price that the floor price needs to be at so that the trader can break even. An option being ITM doesn't mean that the trader is making a profit because there is an initial premium paid.
- ITM for Calls: Strike Price + Premium
- ITM for Puts: Strike Price - Premium