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1. Option Terminology

Understanding options requires familiarity with specific terms:

In the Money (ITM):

Call: Spot price > Strike price

Put: Spot price < Strike price

At the Money (ATM):

Spot price ≈ Strike price

Out of the Money (OTM):

Call: Spot price < Strike price

Put: Spot price > Strike price

Intrinsic Value: The real value if exercised now.

Time Value: Extra premium above intrinsic value due to time remaining until expiration.

Implied Volatility (IV): Expected volatility of the underlying asset, impacting option price.

Delta: Measures sensitivity of option price to underlying price change.

Gamma: Rate of change of delta.

Theta: Rate of decline in option value due to time decay.

Vega: Sensitivity to changes in volatility.

2. Types of Options

Options can be classified based on exercise style and underlying asset:

2.1 Exercise Style

American Options: Can be exercised anytime before expiration.

European Options: Can only be exercised at expiration.

2.2 Based on Underlying Asset

Equity Options: Based on stocks.

Index Options: Based on stock indices.

Commodity Options: Based on commodities like gold, oil, or agricultural products.

Currency Options: Based on forex pairs.

ETF Options: Based on exchange-traded funds.

3. Option Pricing Models

Option pricing is influenced by multiple factors. The most widely used model is the Black-Scholes Model, which calculates the theoretical price of an option based on:

Current stock price

Strike price

Time to expiration

Volatility

Risk-free interest rate

Dividends

Other models include:

Binomial Model: Useful for American options with the flexibility of early exercise.

Monte Carlo Simulation: Simulates random paths to estimate option value.

Factors affecting pricing:

Intrinsic value: The difference between spot price and strike price.

Time value: More time to expiration = higher option value.

Volatility: Higher volatility increases potential for profit, raising option price.

Interest rates: Higher risk-free rates slightly increase call prices.