Basic options terminology. Step by step digest (part 1)

An option is one of the derivative financial instruments.
An option is a contract that gives the buyer the right to buy an asset and the seller the obligation to sell it at a preset price before the expiration date.

There are types of options — American and European options.

American options are the kind of options that delta.theta uses, they can be executed by the buyer at any time from the time of purchase until the expiration date.
European options, unlike American ones, can be executed by the buyer only at the expiration date.

European — derebit, okex, binance
American — hegic, finnexus, opyn

Types of options

CALL — provides the contract holder with the right to buy the underlying asset in the future from the time of purchase until the expiration date at a preset price.
PUT — gives the contract holder the right to sell the underlying asset in the future from the time of purchase until the expiration date at a preset price.

But there are two parties in every option contract: a seller and a buyer, examples are presented below.

Buy Call — the buyer expects the price to rise in the future.
Maximum loss = premium paid
Maximum profit — unlimited, as the asset can continue to move up in price, gaining in value.

Sell Call — the seller expects the price to fall in the future.
Maximum profit = premium received
Maximum loss — unlimited, as the asset can continue moving upwards without any restrictions. On delta.theta you can only sell a 100% covered option (the corresponding value of the underlying asset is set in the contract).

Buy Put — the buyer expects the price to fall in the future.
Maximum loss = premium paid
Maximum profit — unlimited, as the asset can continue to move downwards until the price reaches zero.

Sell Put — the seller expects the price to rise in the future.
Maximum profit = received premium
Maximum loss — unlimited, as the price can continue to move downwards until it reaches zero. On delta.theta you can only sell a 100% covered option (the strike amount is set in the contract).

Basic terms

Strike — a fixed price, stated in the option contract, at which the option buyer has the right to buy (sell) the underlying asset up to and including the moment of expiration.

Premium — the price of the option. Refers to the monetary reward paid by the buyer of an option to the seller for the right to buy (sell) the underlying asset in the future. Option price consists of intrinsic value and time value.

Option Seller — a party that sells the right to buy/sell an asset at the strike price. The seller receives a premium on each trade. An options seller can sell only covered options. It means that seller`s margin should be equal 100% coverage (to sell PUT) or the underlying asset (to sell CALL). Collateral can be deposited through the delta.theta cross-protocol solution on Compound/Venus.

Option buyer — a party that pays a premium to a seller for the right to buy (sell) the underlying asset at the strike price at the moment of expiration.

Expiration — a date on which the option expires. As for delta.theta, the expiration date occurs every Friday. At the same time, considering that the options are American — they can be expired at any time before the expiration date, as long as the option is in the money.

Advanced terms

In the money option (ITM) is a situation in which an option is exercisable. For a call (put) option, this is when the price of the underlying asset is above (below) the strike. There is Intrinsic value.

Out of the money option (OTM) is a situation in which an option cannot be exercised. For a call (put) option, this is when the price of the underlying asset is below (above) the strike. There is no intrinsic value.

At the money option (ATM) is a situation where the price of the underlying asset is equal to the strike. There is no intrinsic value.

Intrinsic value — only available for “in the money” options — is essentially the difference between the price of the underlying asset and the strike. For a call, it is when the underlying asset is above the strike, and vice versa for a put.

Time value is the difference between the option price and intrinsic value (remember that only “in the money”options have intrinsic value). Time value is characterized by time decay — a decrease over time. Furthermore, the decay accelerates as the expiration date approaches.

TV is a theoretical value of the option according to the Black-Scholes model, which is calculated on the basis of the average volatility for 10 days on 3 averages (10, 30 and 60 days). It is a kind of benchmark.
Users are free to put a value higher or lower than a TV, though TV is a baseline followed by all traders

Implied volatility (or IV for short) is an “underlying” volatility, in other words it is the current market valuation.
The higher it is, the more expensive the option will be.

Offset Transaction — a transaction that gives a party of the contract to neutralize the obligations arising from the option by entering into another option. This second option contains conditions that are exactly opposite to the conditions of the first option contract. This process is called in exchange trading “liquidation of the transaction” by means of an equivalent reverse transaction.
You can find an example of an offset deal in our article👉 https://link.medium.com/VUBUx1i8aib