Options trading is luring a lot of inexperienced traders who are looking for supernormal gains. However, most of them end up losing money as they aren't familiar with the basics yet. 8 basics you must know before placing your next trade 🧵: Collaborated with @AdityaTodmal
1/ Option Premium consists of two things: i) Intrinsic value which represents how much money the option would be worth if it were to expire right now. ii) Time value represents the premium you pay since the option does not expire right now.
2/ Intrinsic value: •It is the difference between the strike price and the asset's current market price when the difference is positive. •Intrinsic value for ITM calls> 0. •Positive payoff for the buyer.
3/ Example of identifying ITM options:
4/ Time value aka Theta: • Theta represents the time value decline of an options contract. •Time value is the additional amount over & above Intrinsic value. •Time value on an option with 20 days to expiry > Time value on an option with 2 days to expiry.
5/ Time decay is non-linear: •Means the rate of change increases as the options contract approaches expiration. •Hence option contracts are very volatile on the day of expiry. •An option buyer doesn't want the options to expire worthless & vice versa for an option seller.
6/ How theta/time decay affects you? •After buying an option if the stock moves in your favor & again retraces to the level where you bought option, the value of the option gets eroded. •Hence traders complain of not able to make money despite the favorable stock movement.
7/ Perils of buying deep OTMs: • Many retail traders (unskilled) buy options worth Rs. 20-50 on expiry days expecting that it will quickly double (Hero ya Zero) without following any rules. • Even though they might be lucky once or twice they can't replicate it every time.
8/ Liquidity: • Trading in stock options which has less liquidity will have wide spreads, which means your position is likely to start out in the red. •Go for options that have high liquidity as they have tight spreads.
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