We're on to options trading for dummies part deux. In the first part of our Trading Options for Dummies series, I attempted to help you understand what an option contract is and introduced some of the terminology.
Now we can dig into the factors that affect the price of these contracts, and a solid understanding of these factors will allow any dummy to build a successful options trading strategy.
While these two blogs are a great start to learning how to trade options, we definitely recommend paper trading until you perfect a trade plan – no matter what you’re trading! Also, don’t forget to take the free options trading course on our website!
Getting Dummies to the Greeks
- The Greeks really affect options trading. Hence, options trading for dummies part deux delves into it. There are many factors that go into the price of an option, and how that price changes. The most important factor, of course, is the change in price of the underlying asset – like SPY, going back to the example we used in Trading Options for Dummies Part 1.
The most common method of pricing options is called the Black-Scholes model. This is a fairly complex mathematical finance model that is well outside of the scope of this post.
However, the Greek letters traders use to describe some of the pricing derived from the Black-Scholes model are very important to understanding how to make profits from trading options. So let’s get started!
1. Options Trading for Dummies Part Deux With Delta
Delta measures the rate of change in the value of the option per every $1 change in price of the underlying. For example, a SPY call may have a delta of $.50. That means that the value of the call will increase by $.50 for every $1 increase in price, and will decrease $.50 for every $1 decline in value.
Remember that an options contract represents 100 shares of stock. Premium is always stated in the per share value, so that $.50 change per $1 change in the underlying actually means a $50 gain or loss per contract for an options trader.
Delta for calls can be anywhere between 0 and 1. Because puts increase in value as the price of the underlying decreases, they have a negative delta – between 0 and -1. Delta gets smaller the further out of the money (OTM) the strike price of the contract is.
One cool thing about delta that will definitely make you NOT a dummy when it comes to trading options: the value of delta is the probability of the option.
Keep that in mind when buying a $.05 (you’ll actually pay $5) contract – it only has a 5% chance of expiring in the money!
As apart of options trading for dummies part deux, here's a video with an in depth look into Delta.
2. Options Trading for Dummies Part Deux With Theta
Theta is often referred to as “time decay.” It measures the amount the value of an options contract will decrease every day until expiration, all other things being equal.
Of course, all other things are never equal. The point here is to understand that options decrease in value as time passes.
Theta is always highest for at the money (ATM) options, and it accelerates as it approaches expiration. In other words, the value of an options contract will decrease more rapidly the closer it is to the expiration date of the contract.
This is extremely important to keep in mind when building your trading plan. If you’re swing trading using options, you don’t want to be very close to expiration, as the time decay of theta will be working hard against you.
On the other hand, if you’re a scalper, you may want to trade options that are close to expiration. Theta won’t hurt you when you’re only holding the contract for a few minutes, but the option will be cheaper because theta has already eroded much of the value.
Options trading for dummies part deux wants to make sure you're not hurt by time.
3. Options Trading for Dummies Part Deux With Vega
Vega gets into my personal favorite aspect of options trading; and the central part of the edge I trade. Vega measures the rate of change between the value of the option and changes in the implied volatility of the underlying asset. Implied volatility is a metric for the expected moves in a security.
Implied volatility tends to be higher at times of uncertainly – like around earnings reports or during a global pandemic. Higher volatility results in higher options prices.
Typically, you want to sell options when IV is high, which is my favorite way to trade. However, this is not an options trading strategy for dummies, so we’ll look at my strategy in another post.
Lucien recently made a really great video about implied volatility. While it isn’t Vega, per se, this is a very important video to watch and understand.
Other Greeks in Options Trading
- There are a lot more “greeks” than the three above, but in my humble opinion, those are the most important to understand. A couple others you will definitely hear about are gamma and rho. Gamma measures the rate of change between delta and $1 of the underlying stock. Rho shows how options prices respond to changes in interest rates.
The rest are not needed in options trading for dummies part deux; and probably not for many retail traders at all.
1. Intrinsic vs Extrinsic Value
The next concept to learn in options trading for dummies is intrinsic and extrinsic value. Essentially, intrinsic value is the value of the option if it were to expire at that moment.
For example, if you had a $10 strike call option and price was currently $11, the intrinsic value would be :
$1 x 100 shares = $100.
If the premium for that call option was currently $1.50, $1 of that would be intrinsic value, the remaining $.50 would be extrinsic value.
If price was $9, there would be no intrinsic value, as you wouldn’t buy stock for $10 if it was selling for $9. However, the option won’t be worthless until expiration. Out of the money options only have extrinsic value.
2. Breaking Even
Finally, before no longer being a dummy in options trading, your broker may show you a break even price after you buy an option. This price is not important if you are day trading or don’t intend to hold until expiration.
However, understanding how this number is calculated may help tie all the lessons in these two blogs together.
For call options, the break even price is simply the strike price plus the premium you paid. If you paid $.50 (remember, always x100, so $.50 = $50) for a $10 strike call option, your break even price would be $10.50.
If price was at $10.40 at expiration, the option would be in the money, but you would only profit $40 (10.40 x 100 – 10 x 100 =$40), for a total loss of $10 after buying the option for $50.
For a put, your break even will be the strike price minus the premium paid. Hit us up on Facebook and tell us what the break even price would be for a $10 strike put that you bought for $.50!
Final Thoughts on Options Trading for Dummies Part Deux
I hope these two blogs have helped you gain a better understanding of what options are and how they work. The next step is to continue learning while you start paper trading.
Join us in the live trading room and follow along, practice trading options, and have some fun with us!