“Time eats all the premium but not in all the cases change”

A detailed article

After reading this article you will understand:

Option basics in bullish/bearish scenarios

Basic terminology associated with Options – Spot, Strike, ITM, ATM, OTM, Intrinsic & Extrinsic value of options

Theta and its importance in Option trading

Why most option buyers lose

1/ At the very beginning its better to know the basic-bit about option through following scenarios:

Bullish scenario – Either you can Buy Call (CE) option or Sell Put (PE) option

You buy CE as its value increases if market goes bullish

You sell PE as its value decreases if market goes higher

In both cases you make money

Bearish scenario – Either you can Buy PE or sell CE

You buy PE as its value increases if market goes bearish

You sell CE as its value decreases if market goes down

In both cases you make money

2/ Theta:

T stands for Time, and T also stands for Theta. Theta is a Greek that measures the rate of decay in the value of an option’s premium with respect to time.

In simple words, as the time progresses and option moves towards expiry, its value deteriorates. This is also called Theta decay or time value decay.

Theta works against an option buyer. We will know more in this article but let’s first understand the basic terminology that we are going to use.

3/ Spot Price

Let us assume that Nifty 50 index (not Nifty future) is at 17800. This price is known as the Spot price. Similarly, if Infosys is trading at 1820 in the cash market then this is said to be its spot price. Whatever is the price in cash market is said to be the spot price. Yes, it is that simple.

In standard words, it is the current market price (CMP) of the underlying instrument.

4/ Strike Price

If Nifty is trading at 17800, then you will not only be able to trade the 17800 option but also 17600, 17700, 17900, 18000 and so on. These prices are called the strike price of an option.

In standard words, it is the price at which the owner of the option can buy or sell, the underlying security.

5/ In-the-money (ITM) option

All the CE options with strike price below the spot price are said to be ITM. Similarly, all the PE options with strikes above the spot price are ITM.

In the following table, all CE from 17750 to 17350 (green rectangle) are ITM and all PE from 17850 to 18300 are ITM

6/ At-the-money (ATM) options

If the option’s strike price (either call or put) is identical to the CMP, it is said to be ATM. In the above table you can see that all strikes are 50 points away from each other. So, its not possible to get the exact 17784 strike. We consider 17800, which is very near to the CMP, as ATM.

7/ Out-of-the-money (OTM) options

All the CE strikes above the spot price are called OTM calls and all PE strikes below the spot are called OTM puts. In the table, all CE options from 17850 to 18300 are OTM and all PE options from 17750 to 17350 are OTM.

8/ Extrinsic value is important:

An Option’s price primarily comprises two values — Intrinsic value and Extrinsic value

Option price=Intrinsic value + Extrinsic value

Intrinsic value = Spot price – Strike price

Extrinsic value = Option premium – Intrinsic value

Let us take an example

In this example you can notice that Infy 1760 strike, ITM CE, has an intrinsic value of 60 where as it is zero for 1820ATM and OTM1880 CE options. The former two only have extrinsic value. However, an ATM option may have some intrinsic value in some cases. Ex- if the CMP of Infy is 1822, then intrinsic value of 1820 CE would be Rs.2 and not 0

If the intrinsic value of an option comes out to be negative, as in case of Infy1880CE, it is taken as zero. This is because the value of an option can never be negative. It will be true for all the OTM options

9/ Time & Volatility – The Extrinsic value of a strike is impacted by two factors

The more the value of these factors, the more will be the extrinsic value of an option

An option that’s expiring at the end of month will have more extrinsic value than an option that is expiring this week. This is because there is more time value in the monthly option compared to weekly option

Also, if volatility increases in the underlying stock or commodity, the extrinsic value will increase dramatically in a short duration of time. This often results into sudden spikes in option price.

Therefore, if time and volatility are playing against an option buyer he would lose. In the following picture you can see that time will decay all the premium associated to extrinsic value. So, if the option is not ITM at expiry, it will expire worthless.

The time value will deteriorate at a faster pace as the option goes near expiry or there is very less time to expiry. That is why the dotted line is almost vertical at the end of month. You can observe this scenario in Bank Nifty weekly options on every Thursday (expiry)

The above picture also clarifies that the option buyer will have to pay maximum premium at the beginning of month or an option seller will pocket maximum premium at the beginning of month/series. So, buyer’s money is at more risk than seller esp. when it is an ATM or OTM option.

An ATM and OTM CE bought at beginning of the series will make you money only if the stock goes higher and these options go ITM. Ignoring this reality, most traders still buy OTM CE just because they are cheap. If we again look at Infy Ex, ATM CE has maximum Extrinsic Value (61). It means even if the stock stays at 1820 at expiry, it will lose all Rs.61 premium.

10/ The above Ex. affirms that ATM options have maximum extrinsic value associated with them compared to ITM and OTM. This is because there are higher chances that an ATM CE will become ITM (as the stock goes higher), traders are willing to pay more premium. But that also means more risk in case stock stays lower, because the time value will evaporate.

11/ So now we know that–

While buying options:

Theta works against an option buyer

Almost all Premium in ATM and whole Premium in OTM is the time value

ATM/OTM CE option buyer will lose if underlying stock/commodity goes bearish/sideways

ATM/OTM PE buyer will lose money if stock goes bullish/sideways

ATM options means higher premium and higher volatility

ITM option buyer has relatively higher chances of making money but

If the stock stays sideways, you will still lose the time value (due to Theta decay) in ITM

The risk associated with option buying is the premium paid by the buyer

So, risk is limited and predictable

The profit may be unlimited

While selling options:

Theta works for option seller

CE Option seller will make money in ATM/OTM if stock stays bearish/sideways

PE option seller will make money in ATM/OTM if stock stays bullish/sideways

There is higher probability of making money in option selling compared to option buying

The profit in option selling is limited to the premium earned while selling

There could be unlimited risk associated with option selling if the stock goes against your desired direction

It’s important to calculate risk before option buying or selling.

12/ Options are basically hedging instruments and professional traders use options to hedge risk against their portfolios (by selling option in most cases). Retail traders lose money in options most of the time because of few reasons –

They

Try to play against Theta

Always buy options

Mostly buy OTM options

Do not hedge risk

Greed

Thanks for reading

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