The following are definitions and explanations of key terms related to options.
1. Underlying Assets¶
Underlying assets are the assets upon which an option is based. Underlying assets represent the assets from which the options derive their value. As in the example above, the apples are basically the option’s underlying asset.
In the traditional financial market, the underlying assets are normally stocks, indexes, foreign exchange, or even commodity futures. Here in the crypto market, underlying assets usually refer to a certain type of cryptocurrency, e.g. BTC or ETH.
2. Option Type: Call or Put¶
As discussed above, options are contracts that give the buyer/holder the right, but not the obligation, to sell or buy an underlying asset. They are called call or put options, respectively.
Call options allow the holder to buy an underlying asset at a certain price.
Put options allow the holder to sell an underlying asset at a certain price.
In the specific example above, the fruit store wants to “buy” apples in August, hence, it is buying a call option contract.
If we change the story a bit, the orchard owner worries that the apple price may drop in August, and he wants to fix his minimum profit. Therefore, he reaches a contract with the fruit store, that he may sell the apples at the price of $4/kg in August, but he doesn’t have to if the market price is higher. Then this contract is a typical put option contract.
Also, from these examples, we may see how call and put options work.
As the holder of a call option, he/she expects or concerns that the price may go higher, and hence will be too expensive to buy in the future, therefore, a call option gives him/her cost protection.
As the holder of a call option, he/she holds the underlying asset already expects or is concerned that the price may go lower, and affecting potential future profits, therefore, a put option gives him/her insurance on the profit.
3. Sellers and Buyers¶
A contract normally has two parties, a seller and a buyer. An option seller is selling (shorting) an option contract to a buyer and getting the premium(the price of the option). An option buyer is buying (longing) an option contract from a seller and paying the premium. Also, note that the option can be a call or a put.
4. Strike Price¶
The strike price (or exercise price) of an option is the price at which a put or call option can be exercised. For a call option, the strike price is the price at which the option holders can buy the underlying asset. For a put option, the strike price is the price at which the option holders can sell the underlying asset. It is predetermined in the options contracts.
Also, the strike price can have a big influence on the value of the options. For a call option, the lower the strike price is, which means the holders can buy the asset with lower costs, the higher the value of the option; and vice versa.
5. Expiration Date¶
The expiration date of an option contract is the last date that the contract is valid, on which the holder has the right to exercise the option according to its terms.
Owners of American-style options may exercise at any time before the option expires, while owners of European-style options may exercise only at expiration.
The expiration dates may also have a significant influence on the value of the options. In general, the longer an option contract has to expiration, the higher value it will have.
6. Price Volatility¶
Price volatility, in relation to the options market, refers to the degree of fluctuation in the market price of the underlying asset. Price volatility data sometimes is not easily acquired and often calculated as a prediction of the degree to which underlying asset price moves in the future.
Obviously, the price volatility has a direct influence on the option value. The more volatile the price is, the more difficult it is to make predictions in the future, which gives the option sellers more risk exposure, hence, the value of the option will be higher.
Settlement is the process for the terms of an options contract to be resolved between the holder and seller when it’s exercised. An option contract can be physically settled or cash-settled.
Physically settled options require the actual delivery of the underlying assets. When exercising, the holder of physically settled call options would, therefore, buy the underlying assets, whereas the holder of physically settled put options would sell the underlying assets.
Cash-settled options do not require the actual delivery of the underlying assets. Instead, the market value, at the exercise date, of the underlier is compared to the strike price, and the difference (if in a favorable direction) is paid by the option seller to the owner.
With the apple example above, if the apple price is higher than $4/kg in August, if the options were physically settled options, it would mean that the fruit store purchases the apples at the previously agreed upon price and the orchard owner makes the delivery. If the options were cash settled options, it would mean that the orchard owner pays the difference in cash between the market price and the previously agreed upon price, times the total kilograms covered by the contract, to the fruit store.