An option contract is a derivative instrument that derives its value from its underlying assets(spot). Therefore the prices of the option contract moves in the same direction as its underlying , but how much movement can be expected in an option price with respect to a certain movement in spot is not very certain.
Retail Investors who want to make a quick buck are getting trapped by the fin-influencers who are showing lakhs of rupees in profit on a single trade. A new term is floating in options markets i.e. zero to hero calls where a mere 5-10 rupee premium on expiry goes 20-50x and making a huge amount of profit for the traders. But the reality of it is that this happens one in hundred times and most of the time the premium goes to zero, where retails have to book a loss. Before entering into options trading it is very important to know the basic of options and how the price behaves on different days.
options terminology:
call - CE
put - PE
Strike
ITM - In the Money
OTM - Out of the Money
ATM - At the money
price components
Price of any option contract of stock or index include the current stock price, the intrinsic value, time to expiration or the time value, volatility, interest rates, and cash dividends paid. Lets learn about all these components
intrinsic value-
the intrinsic value is the amount by which the strike price of an option is profitable or in-the-money as compared to the stock's price in the market. If the strike price of the option is not profitable as compared to the price of the stock, the option is said to be out-of-the-money. If the strike price is equal to the stock's price in the market, the option is said to be at-the-money.
time value- Since options contracts have a finite amount of time before they expire, the amount of time remaining has a monetary value associated with it—called time value. It is directly related to how much time an option has until it expires, as well as the volatility, or fluctuations, in the stock's price.
Time Value=Option Price−Intrinsic Value
volatility-An option's time value is also highly dependent on the volatility the market expects the stock to display up to expiration. Typically, stocks with high volatility have a higher probability for the option to be profitable or in-the-money by expiry.
One of the metrics used to measure volatile stocks is called beta. Beta measures the volatility of a stock when compared to the overall market.
there are two types of volatility
historical volatility
implied volatility
interest rates-
it is basically the risk- free interest rate of the country, in India it is calculated based on the RBI 91 days T-BILL interest rate.
Among all the components of the price of an option time value is most important, option prices have an inherent character of decay in them i.e. the price of the option that remains OTM will become zero on the expiry. But on the other hand volatility has the highest impact on OTM options as well so in low volatility environment a sudden spike in volatility on a shorter time frames pushes the prices of OTM options very much thus the name zero-to-hero.
Therefore it is very important for retail traders that before taking any such trade they should know how options work and what is the risk involved in them.