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This is a very common question befalling option buyers since ages. After paying the huge premium and the stock moving in the direction of the option bought if the option buyer sees a loss in options bought they get stressed and start thinking what wrong they did.
This is especially worrisome for novice options traders who just came into the options business. They get worried about seeing a huge decline in option premium if the stock stays in the same place or move slowly in the direction of the option bought. So they ask themselves or their mentors/brokers or keep searching online – why my option declined in price when the stock moved in my option buy direction?
Well, they did nothing wrong except they paid for time value and other things that I will discuss here.
Here is an explanation:
Assuming the stock is at 100 and at the money call option at 100 is bought for 5, then the option buyer will make money only if the stock crosses 105 before expiry. Even if the stock finishes at 104 the option buyer of strike 100 will lose money because he bought the option at strike 100 and paid 5 as premium. So the break-even point is 100+5 = 105. Anything above 105 is profit for the option buyer.
Now coming to the real world live trading. When you buy an option you are racing against time. In Option Greeks its known as Theta. Decay of theta is a big concern for option buyers.
Assuming your view is positive for a stock and your buy an ATM call option paying a hefty premium. The premium you paid for is your maximum risk. Everything is fine and the stock moves up slowly. You will be happy that the stock is going in your direction.
You login to your account happily and to your shock to see your option contracts losing value, means its premium is lower than what you paid for.
This can be frustrating.
Three reasons for this:
One, the stock did not move far enough for you to make a profit yet.
Two, change in implied volatility. If it has gone from a high level of volatility to a lower level the option will lose value.
Three, too much time taken for the move to come.
Please note that option contracts are multidimensional. This is not a simple trade as stock buying and holding. When you buy an option, you buy a lot of stocks by paying a small premium but you also pay for a few things that are not in your control. These are option Greeks. If you do not understand option geeks you can download an Option Greek file from here.
So remember in an option contract, you have this multidimensional issue. You have to not only predict the directional move of where the stock is going, but also how implied volatility and how time decay may impact the position in future. So sometimes even if you get the direction right you may lose money in buying option.
So whats the way out?
Way out is to keep a target to exit. Target should be both for taking loss as well as taking the profits. If you take out the profit and then option moves to make a very high premium you should not repent your decision to exit early. You traded with a plan and you exited.
Trading without a plan is sure-shot way to losing millions in stock markets. You can do my conservative option course and learn ways to set up trades for monthly income.
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