Imagine walking into a high-end restaurant where the menu is written in a language you don't speak. You might end up ordering something you hate or paying far more than you intended. The options market is exactly like that. Before you place your first trade, you must master the "vocabulary" of the options contract.
An options contract isn't just a simple bet; it is a legal agreement with specific parameters. In this module, we break down the five pillars of any option contract: **Spot, Strike, Premium, Expiry, and Lot Size.**
1. Spot Price vs. Strike Price
These two terms are the most frequently confused by beginners, yet they are the most important relationship in any trade.
The current market price of the underlying asset. If you look at Nifty on your TV right now and it says 22,500, that is the Spot Price.
The agreed price at which the contract can be exercised. This is fixed. You choose this from the Option Chain when you enter the trade.
The Relationship: For a Call Option (Buy bet), you want the Spot Price to be higher than your Strike Price. For a Put Option (Sell bet), you want the Spot Price to be lower than your Strike Price.
2. The Premium: What are you paying for?
The **Premium** is the price of the option contract. It is what the buyer pays and the seller receives. But the premium isn't a random number; it is a mathematical output of two different types of value.
A. Intrinsic Value (Real Value)
This is the "real" amount of money you would make if you exercised the option right now. If Nifty is at 22,500 and you have a 22,400 Call Option, the intrinsic value is ₹100. It is the tangible portion of the price.
B. Extrinsic Value (Time Value)
This is the "hope" or "uncertainty" value. It represents the probability that the stock will move further in your favor before the contract ends. As the expiry date approaches, this value slowly melts away to zero. This melting process is technically known as **Time Decay (Theta)**.
3. Expiry: The Ticking Clock
Unlike stocks, which you can hold for 50 years, options have a "best before" date. Once this date passes, the contract ceases to exist and becomes either cash (if it has value) or a worthless piece of digital paper.
Time is Your Enemy (as a Buyer)
In India, Equity Options typically have Weekly and Monthly expiries. Weekly options expire every Thursday, while Monthly options expire on the last Thursday of the month.
4. Lot Size: Trading in Wholesale
Just like Futures, you cannot buy 1 single option. You must buy a **Lot**. The Lot Size is the number of shares bundled into one contract.
• Nifty: 50 units.
• Bank Nifty: 15 units.
• Reliance: 250 units.
If an option premium is ₹100 and the Lot Size is 50, you must pay ₹5,000 (100 x 50) to buy that one lot.
5. Exercise Styles: American vs. European
There are two ways an option can be exercised. It's important to know which one you are trading.
- American Options: Can be exercised at any time before the expiry date.
- European Options: Can only be exercised on the expiry date.
Note: In India, all Index options (Nifty, Bank Nifty) are European. You will see the letter 'E' at the end of the contract name (e.g., NIFTY 22500 CE). However, you can still sell your contract to someone else in the market anytime before expiry—you just can't demand the "physical" settlement from the exchange early.
Summary of Module 05
Mastering these terms is the foundation of becoming a disciplined trader. Without understanding the components of Premium and the weight of Expiry, you are essentially flying a plane without a dashboard.
- Spot is where the market is; Strike is where your contract is.
- Premium consists of Intrinsic and Time value.
- Expiry is when the "game" ends.
- All Indian Index options are European (Cash Settled).
Now that we have the vocabulary, it's time to learn how to categorize options based on their relationship with the spot price. Is your option "rich," "fair," or "empty"? We cover this in the next module: Moneyness (ITM, ATM, OTM).