Options trading gives you the right but not the obligation to buy or sell an asset at a specific price. An options contract is made up of 100 shares of a particular security. Traders can trade large-cap stocks without paying the required capital for purchasing 100 shares of the underlying stock. They’re traded for profit, speculation, and hedging. They have a reputation for being hard to understand. The versatility of options allows for great profit but also great loss. This is why paper trading options is so important. Options trading is complex. It can be very risky if not used properly.
Table of Contents
- How Does Options Trading Work?
- Options Greeks
- Options Trading Strategies
- Options Trading Rules
- Frequently Asked Questions
Options contracts have expiration dates. You can’t hold options forever if you get a bad entry in the hope that the price changes. There are strike prices, which you believe a stock will move to. Strike prices are in the money, out of the money, and at the money. In the money is when the strike price is below the market price of a stock. Out of the money means a strike price is higher (call) or lower (put) than the market price. At the money means, the strike and market prices are the same. Take our options trading course if you need more help.
How Does Options Trading Work?
- Meaning – right but not the obligation to buy/sell a security at a specific price
- Leverage – trade large caps without a lot of capital
- Small Accounts – a good strategy for growing an account
- Diversity – can profit in any market
- Calls – believe the price of the underlying stock is bullish
- Puts – believe the price of the underlying stock is bearish
- Options contract – controls 100 shares of the underlying security
- Expiration – options contracts have an expiration date
- Credit Spreads – sellers collect a premium
- Debit Spreads – buyers pay a debit
Studying implied volatility, time decay, and intrinsic value is also important. These can affect profit and loss as much as the movement of price. It’s important to know that options are more complex than stocks. If you don’t have much money, options can be a good trading strategy for getting started as a trader.
The risk with options is that you can lose your entire investment on a trade. That said, you must ensure that you have good technical analysis basics and knowledge of candlesticks—those two tools and the different parts that makeup options trading.
Understanding calls and puts are options trading for dummies 101. Options contracts are agreements between two parties to buy or sell 100 shares of the underlying stock at a set price – known as the strike price – on or before a certain date, known as the expiration date.
The buyer can “exercise the contract” before the expiration date. But, at the same time, the seller of the contract must fulfill the contract if it is exercised.
There are two types of options contracts: calls and puts. A trader will purchase a call option if they believe the price will increase before the given expiration date.
For example, let’s say that the made-up stock ticker XYZ was trading today at $25/share, and you think it will go up next month.
You could buy 100 shares of the stock at $25 or a call option that expires in a month at the $25 strike price.
This gives you the same exposure to the stock (100 shares). But instead might only cost you $125 instead of the $2500 upfront money to buy the shares.
A put option is the opposite of a call. You would buy a put if you expect price to decrease over the coming month (or whatever time frame you trade).
A put contract gives the buyer the right to sell 100 shares of stock at the strike price, and the contract seller the obligation to buy them. You wouldn’t sell stock for $25 if you could sell them for $30.
But if price decreases to $20, you can short sell the 100 shares short at $25, and buy them back at $20 for a $500 profit, less the premium.
Again, the premium you pay is the most you can lose. While the only limit to your gain is if the stock price goes to $0, where the contract seller will have to pay you $25/share for 100 worthless shares.
Hopefully you’ve noticed that the risk/reward profiles for selling an option vs buying an option are extremely different. An options seller takes on basically unlimited risk for a very limited gain.
While the buyer takes on a defined amount of risk for essentially unlimited profit potential. However, there is a reason for this.
According to Options Clearing Corporation statistics for 2015, only 7% of all options contracts are exercised. In addition, over 70% of contracts are closed before expiration.
Many of the traders in our trade room day trade options!
The money you pay for an options contract is called a premium. The seller of the option receives your $125 premium as soon as the order is executed.
A call option gives you the right to buy 100 shares of XYZ at $25/share, but if the stock price declines to $24, you wouldn’t want to. In this instance, the value of your option would decline until its expiration, when it would expire worthless.
You can sell the contract anytime before expiration and limit your loss. But you can’t lose more than the $125 you paid for the contract.
In this instance, the contract seller would make their max profit – of $125. However, an options seller’s losses are technically unlimited.
If you’re right, and the stock price increases to $30 per share over the next month, the contract seller has to sell you the shares at $25. This would be a $500 loss. However, with the $125 premium collected, the total loss would be $375 – the same as your profit.
What if the stock price went to $1,000,000/share? Unlikely, I know, but in theory, there is no cap to the price a stock can trade for, meaning there is no cap to the profit a buyer of an options contract can make or the loss the seller can make.
Options Trading Grid
Above is an options grid for $SPY, the most liquid trading proxy for the S&P500. You’ll notice that SPY has three expiration dates per week! This is very unusual. Most highly liquid stocks will have a weekly expiration, with the expiration date every Friday. Not all stocks have options, and some will only have a monthly expiration. Volume is just as important for options traders as for trading stock shares.
The options grid begins at the left with a list of the available expiration dates. By clicking the drop-down for the first available expiration, the grid shows calls on the left and puts them on the right, separated by the strike prices.
The grid shows the % change that day and the most recent price the option traded for (this is “MARK” above, that is, the premium paid for that option in the most recent transaction). Also shown is the current bid and ask for each contract displayed.
Let’s look once more at the options grid above. You’ll notice a line in the center of the options grid, where the upper side of the calls side is shaded, and the lower side of the puts is shaded.
SPY was trading at $333.53 at the time of this screenshot. This means that all calls from $333 and lower are “in the money.” In other words, if the option expired at the current price, the option would still have value.
A $333 call option allows the buyer to purchase 100 shares at $333, which could be immediately sold at $333.53, for a $53 profit. The deeper in the money an option is at expiration, the more it is worth.
On the put side, all of the strikes from $334 and above are in the money. A $334 put gives the buyer the right to sell 100 shares at $334, which could be bought for $333.53, for a $47 profit.
The non-shaded contracts are called “out of the money” options. These will have no value at expiration; they will “expire worthless.”
You will commonly see in-the-money options written as ITM; out-of-the-money contracts are abbreviated as OTM. The strike nearest the current trading price of the underlying stock is said to be at the money – ATM.
Many factors go into the price of an option, but the most important factor is the change in the underlying asset’s price. The most common method of pricing options is called the Black-Scholes model. The Greek letters traders use to describe some of the pricing derived from the Black-Scholes model are very important to understand when options trading.
Delta measures the rate of change in the option’s value per every $1 change in the underlying price. 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 by $.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 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 contract’s strike price.
One cool thing about delta that will 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 pay $5) contract – it only has a 5% chance of expiring in the money!
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 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 work hard against you.
On the other hand, if you’re a scalper, you may want to trade options 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.
Vega measures the rate of change between the option’s value and changes in the underlying asset’s implied volatility.
Implied volatility is a metric for the expected moves in a security. Implied volatility tends to be higher at times of uncertainty – 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.
There are many more “greeks” than the three above, but those are the most important to understand. A couple of others you will hear about are gamma and rho. Gamma measures the rate of change between the delta and $1 of the underlying stock. Rho shows how options prices respond to changes in interest rates.
Intrinsic vs Extrinsic Value
The next concept to learn in options trading is intrinsic and extrinsic value. Essentially, intrinsic value is the option’s value if it expires at that moment.
For example, if you had a $10 strike call option and the price was currently $11, the intrinsic value would be:
$1 x 100 shares = $100.
If the premium for that call option were currently $1.50, $1 of that would be intrinsic value; the remaining $.50 would be extrinsic value.
If the price were $9, there would be no intrinsic value, as you wouldn’t buy stock for $10 if it were selling for $9. However, the option won’t be worthless until expiration. So out of the money options only have extrinsic value.
Your broker may show you a break-even price after you buy an option. However, 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 things together.
For call options, the break-even price is the strike price plus the premium you paid. So, for example, 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 the price were $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.
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Speculation and Hedging
Trading options is like everything else; it’s speculation. When you’re speculating, you’re betting on the outcome of a future price movement. Hence the need to understand technicals and candlesticks. If you believe the price of a stock will go up, you will buy a call hoping to profit. Buying a call option instead of shares is attractive because you get leverage. This is where trading weekly options become fun.
A call option costs just a fraction of purchasing 100 shares of the underlying stock. However, it’s important to remember that buying call options is very risky. If you’re directionally wrong on the trade, you lose money, and the options contract could expire worthless. The same thing happens with buying puts.
You have to be correct in which direction you think an asset will move and your timing. For example, suppose you’re using options to hedge another position. In that case, you have a large position and would buy the options, which would gain in value if you were wrong—hedging while trading stock options reduces risk at a reasonable price. It’s like using options as insurance. You take advantage of moves in the stock market while reducing your risk for a cost.
Options Trading Strategies
- Calls and puts – directional options buying strategy
- Naked options – directional options selling strategy
- Credit spreads – slightly directional selling strategy
- Debit spreads – directional buying strategy that limits the risk
- Iron condors – limited risk, non-directional
- Iron butterflies – aggressive, neutral strategy
- Straddles – aggressive directional strategy
- Strangles – aggressive directional strategy
- Covered calls – income-generating strategy
- Calendar spreads – time decay strategy
Vertical spreads are a combination of buying or selling calls and puts. They combine speculation and hedging. You buy/sell one option to cover another. This is where the versatility in options trading comes into play. You can trade spreads in any market. Even a market that’s trading sideways.
Spreads limit risk your risk with options trading, but they also limit profit as well. Although, that’s not necessarily a bad thing. Especially with the Greeks and the different moving parts of an options contract.
Debit spreads are a directional buying strategy that includes buying and selling calls or puts, creating a debit—this combination of buying and selling limits the risk of buying a call or put by itself.
Credit spreads are a limited/neutral selling strategy that includes the selling and buying calls or puts—this combination of selling and buying nets you a premium. The goal of this strategy is for the option to expire worthless, and you collect the premium.
Iron condors are a strategy that allows traders to capitalize in any market. It can be frustrating when trading hits those range of days or weeks. Nothing seems to be hitting the stock scanners, and the trade rooms are trying to find plays.
That’s where the iron condor comes to the rescue. They’re limited-risk non-directional plays. They do best when there’s low volatility. In essence, an iron condor is a combination of spreads. For example, a bull put spread and a bear call spread.
Straddles and Strangles
Straddles and strangles are other types of options strategies. They both allow you to make money whether the stock moves up or down significantly.
Both options require buying the same number of calls and puts with the same expiration date. The difference between the two types of options is that a strangle has two different strike prices, whereas a straddle has the same strike prices.
This could be a good earnings style of trade. You don’t know whether earnings will be good or bad. As a result, you’d trade a straddle. You’d profit whether the stock moved significantly up or down.
For example, you decided to buy stock XYZ at earnings. You decided on buying the May call and put for a strike price of $15. The call costs $3, and the put costs $2. The trade would cost you a total of $500. $3+$2=$5, and remember, one contract controls 100 shares, so you’d multiply that by 100 to get $500.
A straddle profits because you own both a call and a put, so you’re making money in whatever direction it chooses. However, it’s important to remember that one of the contracts will lose.
As a result, to profit, you’d need the direction to move more than $3. While a straddle has no directional bias, a strangle does. With a strangle, you believe a stock will move in a certain direction.
However, you buy the opposite contract to protect yourself. This is because straddles are cheaper and don’t need such a significant move to break even.
Options Trading Rules
Avoidable Mistake #1. Buying Out Of the Money (OTM) Call Options
They’re cheap and appealing, but…they’re challenging to make money consistently on because the probability of success is so low. Stock options trading can go down the tubes with OTM options if you don’t know the correct strategy to trade them.
What to Do Instead?
If you’re stock options trading, why don’t you consider selling an OTM (out-the-money) call option on a stock you already own? Your risk is next to nothing as you already own the stock.
This is known as a covered call strategy, and it has the potential to make you money. That is, of course, if you’re willing to sell your stock if it goes up in price. In addition, this strategy allows you to dip your toes in the options trading world. You get a feel for how OTM option contract prices change as expiration approaches and the stock price fluctuates.
Your risk lies in selling the stock if the price rises and your call is exercised. So if you’re willing to assume this risk, selling otm spreads might be a good method. And it’s certainly a better probability than buying OTM calls.
Avoidable Mistake #2. Trading Illiquid Options
Liquidity refers to the probability that the next trade gets executed at a price equal to the last. It’s about how quickly you can buy or sell something without causing a ripple effect. In this case, the ripple is a significant price movement we don’t want.
To prevent a ripple effect, we need a liquid market. In other words, one with ready buyers and sellers all the time.
When we compare the stock and options markets, we see that stock markets are more liquid. And this is due to a straightforward reason: stock traders are trading just one stock — options traders have dozens of options contracts to choose from.
Stock traders will flock to a hot and running stock: one price, one share. But, options traders could have ten different expiration dates and a million strike prices.
Okay, I may have exaggerated slightly, but you get my point. Unfortunately, more choices, by definition, mean the options market will probably not be as liquid as the stock market. Remember that stock options trading works during options market hours.
Take a large stock like IBM, for example. Liquidity is usually not a problem for stock or options traders. Where we see the problem creeping in is with the smaller stocks. For example, Planet Green Earth, my (imaginary) environmentally friendly energy company, might only have a stock that trades once a week. And, by appointment only – imagine that! So, all things considered, if the stock is this illiquid, the options on Planet Green Earth will likely be even more inactive. What ends up happening is an artificially wide bid-ask spread on the option – this is what you don’t want.
Let’s look at it this way; if the bid-ask spread is $0.20 (bid=$1.80, ask=$2.00), and you buy the $2.00 contract, you pay a full 10% of the price paid to enter the position.
It doesn’t take a genius to figure out you just took a position with a 10% loss right out of the gate. Not a good idea. Moral of the story: Don’t burden yourself; never choose an illiquid option with a wide bid-ask spread.
What to Do Instead
Try to make sure the open interest is at least equal to 40 times the number of contracts you want to trade. For your reference, open interest is the number of outstanding option contracts that have been bought or sold to open a position with a particular strike and expiration date. Let’s do the math to trade a 10-lot. If it’s a 10-lot, your acceptable liquidity should be 10 (number of contracts) x 40 which equals an open interest of at least 400 contracts.
Avoidable Mistake #3. You Wait Too Long to Buy Back Short Options
Here are a few reasons why traders wait too long to buy back short options:
- They are cheap and don’t want to pay the commission
- They hope the contract will expire worthless
- They are greedy and want to squeeze as much profit as possible from the trade.
What to Do Instead?
Be smart and know when to buy back your short options. Better yet, always be ready and willing to repurchase them early.
Look at it like this; if your short option gets way OTM and you can buy it back profitably, do it. Take your risk off the table, don’t be cheap.
Here’s a good rule of thumb to determine when to buy back your short option: Buy it back if you can keep 80% or more of your initial gain from the sale of the option. Otherwise, one day a short option could come back to bite you because you waited too long.
Frequently Asked Questions
- Take an options trading course
- Read books on options
- Interact with other traders on social media and forums
- Join a trade room where you can see how to trade options
- Watch live streams