In this ultimate comprehensive guide, we will go through everything you need to know about options trading so you can start right away.
Table Of Contents
Options Definition
Types of Options
Option Styles
Option Assignment and Exercise
Types of Strategies
The Greeks
Summary
Options Definition
The term option refers to a financial instrument that is based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset.
Key terms:
1 option represents 100 shares of the underlying stock.
strike price – fixed price at which the owner of the option can buy or sell the underlying security. You choose the strike price when you initiate the contract.
expiration date – when the options contract expires. When you buy an options contract you set the strike price and the expiration date under the options chain or options matrix (same thing).
It is a list of all available options contracts for a given security. Options expire on the 3rd Friday of every month.
You can acquire an option that expires in two years or an option that expires in a couple of days.
What happens when options expire?
Both call and put options have an expiration date. If you don’t exercise your options at the expiration date, your options will expire worthlessly.
Difference between a stock and an option – a stock does not have an expiration date, an options contract has an expiration date.
With one option you can mirror the returns from 100 shares, so it is cheaper. An options contract also magnifies your returns.
By holding an options contract, you don’t own a stock. But your returns will be impacted by the underlying stock movement and the type of options contract you hold.
Moneyness (ITM, ATM, OTM)
ITM (In The Money) – Favourable Strike Price in relationship to the underlying security. If it is a call, the underlying stock is trading above the strike price. If it is a put the underlying is trading below the strike price.
ATM (At The Money) – When the strike price equals the stock price
OTM (Out Of The Money) – If it is a call, it means that the strike price is above the underlying security. If it is a put, it means that the strike price is below the underlying security’s trading current trading price.
Types of Options
There are 2 types of options: calls and puts.
And for each of these 2 options, you can either be a buyer or a seller.
Example:
-You can buy a call or you can buy a put.
-You can sell a call or you can sell a put.
That’s it. That’s what we have to work with.
How does this work?
-When you buy a call, you are betting that the stock will go up.
-When you buy a put, you are betting that the stock will go down.
-When you sell a call, you are betting that the underlying stock will go down and the option will expire worthless
-When you sell a put, you are betting that the underlying stock will go up and the option will expire worthless
Options Buyer(wants to exercise the option)
Calls:
Max profit: unlimited. To make a profit, the underlying must always be above the strike price
Max loss: premium
Gain: if underlying is above the strike price(If the stock price is below the strike price at expiration, then the call is out of the money and expires worthless.)
Breakeven(your gain/loss: $0.00) = Strike Price + cost per option(premium). Breakeven status is always in the money
Net Profit = Stock Price – (Strike Price + Premium)
STRATEGY:
With calls, you want the lowest possible strike price, but knowing that the stock price at exercise must be as high as possible.
Remember that the strike is a cost.
So, at exercise:
Example:
premium is $1
Current Stock Price is $10
Strike Price is $9
Total Profit = $1.000 – ($900+$100) = $0.00
->You are going to choose a stock you think is going to go up, because currently, it is trading at a discount.
->Choose the strike price as close as possible to breakeven, so that when the stock regains its historical value or it will go up based on your assessment, you will gain the most profit, because as soon as it is higher than (strike+premium), you make money.
->Choose a long expiry date, so that you leave it room to breathe. (the cost is higher, but you have more time)
Puts:
Max profit: Strike Price – Premium. To make a profit, the underlying must always be below the strike price
Max loss: premium
Gain: if underlying is below the strike price(If the stock price is above the strike price at expiration, then the put is out of the money and expires worthless.)
Breakeven(your gain/loss: $0.00) = Strike Price – cost per option(premium). Breakeven status is always in the money
Net Profit = Strike Price – (Stock Price + Premium)
Example: stock XYZ, trading at $40 per share. You buy a put on the stock with a $40 strike price for $3 with an expiration in six months
Breakeven =40-3 = 37 So you only start making money if the stock is under 37
If the stock is above the strike at expiration you lose the Premium.
Options Seller(wants the option to expire worthlessly. You are betting against the option buyer. )
STRATEGY:
With puts, the stock price must be trading below the strike price+the premium
Example:
premium is $1
Current Stock Price is $9
Strike Price is $10
Total Profit = $1.000 – ($900+$100) = $0.00
Call Seller (naked call):
Max profit: Premium
Max loss: Unlimited
Breakeven: Strike+Premium
> Assumes the obligation [not the choice] to sell the underlying when the call buyer exercises his option.
> Will receive a premium for that obligation to sell [from the buyer of the option]
> Will be willing to see the underlying price decreasing.
At expiration:
Market Price>Strike: in the money(loss)
Market Price<Strike: in the money(gain)
Market Price=Strike: in the money(gain the premium)
>As a call seller your maximum loss is unlimited.
>Your maximum gain as a call seller is the premium already received.
Put Seller:
Max profit: Premium
Max loss: Strike-Premium
Breakeven: Strike-Premium
> Assumes the obligation [not the choice] to buy the underlying when the put buyer exercises his option.
> For that assumption you will receive a premium [from the buyer of the option]
> Will be willing to see the underlying price increase.
At expiration:
Market Price<Strike: in the money(loss)
Market Price>Strike: out of the money(gain)
Market Price=Strike: at the money(gain the premium)
>As a put seller your maximum loss is the strike price minus the premium.
>Your maximum gain as a put seller is the premium received.
Option Styles
European option: Can be exercised only at expiration(European options are also traded in America)
American option: Can be exercised any time before or at expiration(American options are also traded in Europe)
Bermuda Options: A Bermuda option can be exercised early, but only on a set of specific dates before its expiration.
These exercise dates are often set in one-month increments.
Premiums for Bermuda options are typically lower than those of American options, which can be exercised any time before expiry.
Option Assignment and Exercise
Situation where the option seller has to fulfil the obligation agreed upon in th eoptions contract by either buying or selling the underlying security at the strike price(exercise price)
-If a call option is assigned, the call option seller has to sell the underlying security at the strike price(it is ITM)
->The call buyer exercises his right to buy so the option seller is assigned the obligation to sell
-If a put option is assigned, the put option seller has to buy the underlying security at the strike price(it is ITM)
->The put buyer exercises his right to sell so the option seller is assigned the obligation to buy
Types of Strategies
1.Covered Call – sell a call, covered by a long position in the asset
2.Naked call – same as selling a call
3.Married put – buy at-the-money put + long position on the stock
4.Credit Spread – sell high-premium option and buying a low premium option.
5.Debit Spread – buy high-premium option and sell a low premium option.
6.Straddle – buy both a put option and a call option for the underlying security with the same strike price and the same expiration date.
7.Strangle – holds a position in both a call and a put option with different strike prices, but with the same expiration date and underlying asset
8.Iron Condor – An iron condor is an options strategy consisting of two puts (one long and one short) and two calls (one long and one short), and four strike prices, all with the same expiration date.
The iron condor earns the maximum profit when the underlying asset closes between the middle strike prices at expiration. In other words, the goal is to profit from low volatility in the underlying asset.
The iron condor has a similar payoff as a regular condor spread, but uses both calls and puts instead of only calls or only puts. Both the condor and the iron condor are extensions of the butterfly spread and iron butterfly, respectively.
9. Butterfly Spread – The term butterfly spread refers to an options strategy that combines bull and bear spreads with a fixed risk and capped profit.
These spreads are intended as a market-neutral strategy and pay off the most if the underlying asset does not move prior to option expiration.
They involve either four calls, four puts, or a combination of puts and calls with three strike prices.
The Greeks
Delta – Delta measures the amount by which the price of an ption will change, up and down, every time the underlying stock moves 1 point.
Longer-term trading, choose low-delta, shorter-term trading, choose high-delta.
Calls have a delta between 0 and 1
Puts have a delta between 0 and -1
In-the-money options will rapidly approach 1 (calls) and -1 (puts) as expiration approaches.
Out-of-the-money options will rapidly move towards 0 as expiration approaches.
Gamma – If Delta is the “speed” at which option prices change, you can think of Gamma as the “acceleration”.
Options with the highest Gamma are the most responsive to changes in the price of the underlying stock.
Theta – Measures the daily rate of decline in an options vlaue, as it nears its expiration date. Theta is the time decay options value.
Suppose an option has a strike price of $1.150 and a Theta of $53.80, assuming nothing else changes, its value will be $1.096.20 after one day passes, $1.042.40 after two days.
Vega – Vega is the option’s sensitivity to changes in implied volatility. A rise in implied volatility is a rise in option premiums, and so will increase the value of long calls and long puts.
Vega increases with each expiration further out in time.
Here is a theoretical example to demonstrate the idea. Let’s look at a stock priced at 50. Consider a 6-month call option with a strike price of $50:
If the implied volatility is 90, the option price is $12.50
If the implied volatility is 50, the option price is $7.25
If the implied volatility is 30, the option price is $4.50
RHO – Rho is the amount an option will change based on a one percentage point change in interest rates.
Most traders ignore Rho. If you’re trading short-term options, changes in interest rates will not have much of an impact.
The only options that tend to be materially impacted by interest rates are LEAPs due to the change in the “cost of carry”.
Delta Theta Ratio – The Delta Theta ratio is the most important Greek Ratio. It is literally the position Delta divided by Theta.
With options income trading, we are aiming to maximize Theta. We want time decay working in our favor.
If we want Theta to be the major driver in the trade, then we want Delta to be very low in proportion to Theta.
Summary
In this ultimate comprehensive guide, we went through the key concepts about options trading so you can get started right away.
