Essential Trading Terms Explained High-impact trading concepts such as intrinsic value, time value, breakeven points, risk-reward ratio, required margin, and probability of profit (POP) shall be learned. In this extensive article, you will learn how these terms affect your trading strategies, employed risks, and overall approach. Ideal for traders desiring to improve their market understanding and make better profits from trades, find out how you can apply these ideas to your trading to get better results.
1. Intrinsic Value
The most familiar of all the measures of value is the intrinsic value, which means the real value of the available option bearing reference to its current price in relation to the stock. It holds only true for the money options.
For a Call Option: The intrinsic value is the equal to the strike price of the call option minus the present price of the asset, provided that the price of the asset is more than the price of the call option.
For a Put Option: The put option value as part of its intrinsic value, is the strike price of the put less the price of the underlying asset if that asset is worth less than the strike price.
In other words, if you have bought a call option for ₹ 50 such that the present market rate of the share is ₹ 60 then the actual value of the option is ₹ 10.
2. Time Value
Time value connotes that part of the option’s price that cannot be explained by the stock’s intrinsic price. It represents the possibility to increase the value of the option before the time it expires because of time until the expiration and fluctuation in the market.
It also reduces the value as the time to expiration draws near a phenomenon known as ‘time decay’. The nearness of an option to expiration is accompanied by a reduced time value.
TV = OP – IV
For example, to calculate the premium of an option, you may have to pay ₹15 while the intrinsic value is ₹10, this means that the time value is ₹5.
3. POP (Probability of Profit)
POP stands for Profitable Option Position, the likelihood of making a profit on an option trade. It best represents the probability of an option position turning out to be profitable at expiry time.
There are various practices employed in the determination of the POP by the traders, and these include other statistical data on the asset and volatility of the asset, among others. For instance, while selling options or employing such tactics as spreads may often guarantee profit, they do it at the same time, a lower likelihood of gain with much potential.
4. Breakeven
The breakeven point therefore refers to the price that the option holder does not gain, though he is also not in a position to lose money. It is this price of the underlying asset at expiration to wipe out the profit/loss of the trade that we are considering.
For a Call Option: Breakeven = Strike Price + Amount Paid for the Premium
For a Put Option: Breakeven = Strike Price – Amount paid for the premium
That is, for example, if you buy a call option with a strike price of ₹50 for a price of ₹5, the breakeven point would be ₹ 55 the ₹ 50 strike price + the ₹5 premium.
5. Final Margin
The final margin is calculated as the margin that a trader requires to hold such a contract until its expiration. This margin guarantees the trader an ability to afford any loss in his position in the market.
These final margins are determined based upon the categories of assets under transactions, the position size, and volatility. This must be kept to prevent the position from being margined out, or else the account balance will be negative.
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6. Required Margin
The required margin is the amount of capital that is needed to open an active position on the market by a trader. These are refunds for security deposits that may be forfeited in the event that some losses are incurred.
It depends upon the extent of leverage used, trading’s format, such as futures trading or option trading, etc., and the actual volatility of the asset that is under trading.
For instance, in futures trading, a margin call is a very small percentage of the overall futures contract value.
7. Risk-Reward Ratio
The risk-reward ratio is practically utilized to express the possible profit of a trade concerning the possible loss.
Risk-reward ratio equation = Risk as measured by average potential loss / Average potential reward
For example, if you’re risking ₹100 to potentially make ₹300, the risk-reward ratio is 1:3. Traders often seek a risk-reward ratio of 1:To make sure that the trade reward is proportionate to the risk undertaken, the ideal figure gage should be 2 or higher.