Originally posted on https://investormint.com/investing/options-trading-for-dummies
Trading stocks is quite intuitive. When you buy a stock at a low price and sell it at a higher price, you make money. But trading options is a whole other ball game.
Before you get off the starting line, you are met with new options terms like theta, gamma, vega, and strike price. It is easier to stop in your tracks and go back to the simpler world of stocks. But hang in there!
Options can be used to protect your portfolio, generate consistent income, make money when stocks fall, and profit from volatility.
Trading options can also be risky if you do not know what you are doing. However, if you invest a little effort to learn options trading terms and definitions, you will discover how options can lower portfolio risk and produce a regular cash flow.
Options Trading For Dummies:
Terms and Definitions
If you are just getting started with options, the first step is to learn basic options definitions.
Strike prices, premiums, and contracts can sound intimidating at first but rest assured you can get up to speed quickly.
The first thing to note is that two types of options exists: call options and put options.
OPTION TYPES: CALLS AND PUTS
Both call and put options are contracts that have rights associated with them.
- A call is the right to buy stock at a fixed price for a specific time period.
- A put is the right to sell stock at a fixed price for a specific time period.
These rights can be both bought and sold. For example, you can buy a call option, which gives you the right to buy a stock for a duration of time at a specific price. Or you can sell to someone else the call option, which gives them the right to buy the stock for a period of time at a specific price.
Similarly, you can buy a put option, which gives you the right to sell a stock at a fixed price for a specific time period. Or you can sell the put to someone else, which gives them the right to sell the stock at a fixed price for a fixed duration.
How Are Options Different From Stocks?
People invest in stocks for a variety of reasons. Here are some of the most common ones:
- Dividends. Certain stocks give its shareholders a small percentage during the year in the form of dividends for being shareholders. This helps to entice you to hold on to your shares or buy more of them.
- Own part of a company. Individuals who invest in companies, such as Coca Cola or Uber, become part owners in the company without taking on the burden of operating to earn returns.
- Buy-and-hold. Over time, stocks have historically risen in value. Whether due to rising tides in the economy, inflation, or company growth, the returns from longer term buy-and-hold investments can be significant if you pick the right stocks.
Why Investors Trade Options
Investors trade options for several reasons, including:
- Income Potential. Covered calls provide flexibility to trade with both stocks and options. This strategy lowers your risk of losing your investment while providing a way to generate income.
- Hedge against downside risk with married put. Traders may also select options because they can offset the risk of a falling price by leveraging a married put.
- Cost efficiency. Options are also attractive to investors thanks to their cost savings. Options often require less money for investing since you can buy several shares in one option.
A key difference between stocks vs options is that you have a time limit trading options because they expire at some point.
Also, if the option value doesn’t increase as you had hoped, you run the risk of losing your initial investment. However, because of the higher risks, trading options often can yield a much higher return than investing in stocks.
That’s why buying stocks are ideal for beginner or long-term investors. However, if you’re a more advanced investor who wants trading flexibility or then, trading options may be an attractive investment to consider.
Options Trading For Dummies:
Obligations When Selling Options
When you start a trade by selling an option, you create an obligation to buy or sell stock.
When you sell a call option to another trader who chooses to exercise their right to buy the underlying stock, you are obligated to sell the stock to them.
And when you start a trade by selling a put option you take on an obligation. If the trader who you sold the put option to decides to exercise their right to sell the stock, you must buy it from them.
- When you begin a trade by selling a call option, you incur an obligation to sell stock if assigned (meaning if the call buyer exercises their right to buy the stock).
- When you start a trade by selling a put option, you assume an obligation to buy stock from the put purchaser if they choose to sell the stock which is their right.
When you start a trade by selling an option, you take on the following obligations:
|Obligation||Sell Stock||Buy Stock|
Options Can Be Bullish OR Bearish
Beginner traders generally learn about call options first because they are the simplest options to understand.
Buying a call option is easy to understand because in some ways it mirrors buying a stock. When you buy a stock low, and it rises, you can sell it for a profit. Generally, you can buy a call at a lower price and sell it at a higher price for a profit when the underlying stock rises.
For this reason, beginner options traders sometimes think calls are always bullish, meaning they only make money when stocks rise. But call options can also make money when stocks fall. It just depends on whether you start a trade by buying the call or selling the call.
Call options are not always purchased to begin a trade. It is possible to start a trade by selling calls too. And when you sell a call to start a trade, you make money when the stock goes lower, so selling calls is labeled a bearish strategy, meaning you make money when stocks fall.
So, calls can be either bullish or bearish. If you buy a call to start a trade, you want the stock to rise to make money, so buying calls is bullish.
Whereas when you sell a call to begin a trade, you want the stock to fall to make money, so selling calls is bearish.
Similarly, put options can be bought and sold to start trades.
You can buy a put option to start a trade which makes money when a stock falls, and so is bearish.
Or you can sell a put option to begin a trade, which makes money if the underlying stock rises, and so is bullish.
Options Terms: Strike Price
We mentioned that calls and puts can be bought and sold at specific prices. These prices are called strike prices.
More formally, a strike price is defined as:
- The pre-agreed price at which stock is bought or sold depending on the rights or obligations of the call or put contract.
CALL STRIKE PRICES
If you were to buy a call option at a strike price of $100, it means that no matter how high the stock goes, you always have the right to purchase the stock for $100. Even if the share price increased to say $200, you could still buy the stock for just $100.
That might seem like a good deal and almost too good to be true. But remember someone else is on the other side of the trade, and for them that outcome would be very costly.
The person on the other side of the trade sold the call option, and they have an obligation to sell the stock to you when you decide to buy it.
With the stock up at $200, they are still obligated to sell it to you for just $100. If they don’t own the stock, they must first buy it at the current price of $200 before selling it back to you for $100, resulting in a loss of $100 per share.
As you can quickly see, when you begin a trade by selling calls, the risk is high. For this reason, many brokers impose strict restrictions on selling calls when you don’t own the underlying stock.
Selling calls when don’t own the underlying stock is described as selling naked calls. And naked calls are generally only appropriate for the most sophisticated and deep-pocketed of options traders.
A much safer and more popular strategy is when you own stock and sell a call(s) against it. This strategy is called the covered call, and is one of the safest and best options trading strategies to produce consistent income.
Top options trading platforms, such as tastyworks, make it easy to place covered calls.
PUT STRIKE PRICES
When you purchase a put option, you do so at a specific strike price. This gives you the right to sell stock at a pre-agreed price for a fixed time period.
For example, if you buy a put option at a strike price of $50 and the stock falls to $30, you still get to sell the stock at $50, even though the current share price is $30.
As good a deal as that sounds, keep in mind that some other trader is losing that $20. When you exercise your right to sell your stock, the trader on the other side must buy it from you. So, they are required to buy the stock at $50, even though it’s only trading at $30.
It may seem like a raw deal for the other trader, and it gets worse if the stock continues to fall. But keep in mind the trader who sold you the put option is like an insurance salesperson who is betting on a good outcome.
The put seller pocketed a premium when the trade was opened and their bet was the stock wouldn’t go lower. If the stock had moved higher they would have made money. In fact, even if the share price remained flat they would have made money.
Like an insurance company, the only time the put seller loses is when there is a bad outcome – when the stock falls.
As the put buyer, you would have lost money if the stock had risen because buying puts to start a trade is a bearish strategy.
Because you took money out of your pocket to pay for the put option, you essentially purchased the equivalent of an insurance policy.
When the stock dropped, your insurance contract gave you the right to sell your stock at the higher price. Similarly, if you paid for a car insurance policy and subsequently got into a car crash, you could cash in your policy and buy a new car.
Holders and Writers
When you buy an option, you are the holder of the option. You may be a call option holder or a put option holder.
As the holder of an option, you have a lot more control than an option writer. For example, you can exercise your right to buy or sell stock, depending on whether you own a call or put respectively, anytime you wish up until expiration.
In contrast, when you sell an option, you are labeled an option writer. When you sell calls, you are a call writer, and when you sell puts, you are a put writer.
Writing calls can be highly risky if you don’t own the underlying stock. These uncovered calls are labeled naked calls and the risk you incur when selling these calls is theoretically unlimited; when the stock goes higher, your risk and loss increases.
Writing puts is also somewhat risky though not nearly as risky as writing calls. When you sell puts, you are entering what is called a naked put position. If the stock goes lower, you must fulfill your obligation to buy the underlying stock if assigned.
The maximum you can lose in a naked put position is the amount you pay for the stock minus the amount received when you sell the put.
Unlike stocks, options exist for a fixed duration of time and then the option contracts become void. You can theoretically hold a stock forever, but an option will eventually expire based on its expiration date.
- The expiration date is the date when an options contract becomes void.
Purchased calls and puts may be exercised at any time up to the expiration date.
For example, if you buy a call, you can exercise your right to buy the underlying stock up to the expiration date. And if you buy a put option, you can exercise your right to sell the stock at any time up to the expiration date.
When you sell an option, it may be assigned at any time up to the expiration date.
For example, if you sell a call option you may be assigned an obligation to sell the underlying stock and if you sell a put option you may be assigned an obligation to buy the underlying stock.
Options Definitions: Intrinsic and Extrinsic Value
When you buy or sell call or puts you either pay for or receive an amount, called the option value, which has two components: intrinsic value and extrinsic value, also known as time value.
- Intrinsic value is the difference between a stock price and a strike price when an option is in-the-money.
A call option is in-the-money when the share price is higher than the call strike price.
A put option is in-the-money when the share price is lower than the put strike price.
If a call option strike price is higher than the current share price, it is labeled an out-of-the-money call while a put option is out-of-the-money if its strike price is below the current share price.
When both the share price and strike price of an option are approximately equal, the option is termed at-the-money.
- Extrinsic value is the value an option has over and above its intrinsic value.
Extrinsic value or time value erodes as the expiration date approaches because of a factor called theta, which is one of the so-called “option greeks” that affects the price of an option.
Options Trading For Dummies: Option Greeks
One of the most important components of this options trading for dummies guide is option greeks, which are measures of risk that affect the pricing of an option.
Option greeks are named after letters of the greek alphabet for the most part, with vega being the exception, as follows:
- Delta measures the rate of change of an option for a unit change in the underlying stock.
For example, if delta is 0.50 for a call, it means that when a stock goes up $1, the call option value increases by $0.50.
Deltas can be positive and negative.
|Start Trade By||Call||Put|
|Buying||Positive delta||Negative delta|
|Selling||Negative delta||Positive delta|
- When you buy a call, the delta is positive; the call makes money when the stock rises;
- When you buy a put, the delta is negative; the put makes money when the stock falls;
- When you sell a call, the delta is negative; the call makes money when the stock falls;
- When you sell a put, the delta is positive; the put makes money when the stock rises.
Delta and theta are perhaps two of the most important options greeks, because they have arguably the greatest impact on the price of the option.
- Theta measures the rate of decay of option premium due to the impact of time.
As an option approaches its expiration date, the time value or extrinsic value erodes bit by bit, all else being equal. Every day the option loses some value due to theta, and the closer it is to expiration, the faster the decay rate.
Theta lets you know by how much the option decays in value. For example, if theta is -0.15, it tells you that each day the option will lose $0.15 in value because of time-decay.
Gamma can be one of the harder greeks to understand because it affects delta, which in turn affects the options price.
- Gamma measures the rate of change of delta relative to the underlying stock.
If gamma is 0.10, and delta is 0.50, then when a stock changes value by $1, the delta increases to 0.60 or decreases to 0.40 depending on whether gamma is positive or negative respectively.
The one option greek that isn’t labeled after a greek alphabet letter is Vega.
- Vega measures the rate of change of an option’s price when changes in implied volatility occur.
If vega is 0.20, then the option will increase in value by $0.20 if the implied volatility rises by 1%.
The least important option greek to pay attention to is Rho because it changes so infrequently and has a comparatively small impact on an option’s price relative to other greeks.
- Rho measures the rate of change of an option’s price when interest rates change.
A 1% increase in interest rates would increase the price of a call option from $1.10 to $1.15 if rho were 0.05.
Options Trading For Dummies: The Options Chain
When you buy a stock, you are quoted a Bid and an Ask price. You pay the ask price when you buy a stock and you receive the bid price when you sell a stock.
When you buy and sell options, it gets a little more complex. You can buy or sell different options on the same stock at different strike prices over different time durations.
Here’s an example of an options chain where the underlying stock is trading at $124.10.
|Strike||Bid||Ask||Volume||Open Interest||Implied Volatility|
The focus of the options chain is on call options. You can spot this visually because the shaded areas are in-the-money call options; the strike prices are less than the share price of $124.10.
- Ask Price: This is the price you pay to purchase an option.
- Bid Price: This is the amount you receive when you sell an option.
- Volume: This is the daily number of contracts traded.
- Open Interest: This is the total number of contracts open.
- Implied Volatility: This is sometimes labeled IV and it measures the likelihood of a price move.
If a company’s earnings announcement is imminent, implied volatility will generally spike higher for most stocks. This reflects the expectation that the share price will move by a larger amount than normal when the news is released.
When implied volatility is elevated, the pricing of options is adjusted higher. It becomes more expensive to buy options and more premium is received when selling options.
Usually after earnings have been released, implied volatilities return to more normal levels soon afterwards.
- In-the-money: In the options chains above, you will see the call options with strike prices lower than the share price are in-the-money.
- Out-of-the-money: Call options with strike prices higher than the share price are out-of-the-money.
- At-the-money: When the strike price and share price are about equal, the option is said to be at-the-money, like the strike 124 option in the options chain above.
Technically, the 124 strike price option is in-the-money because it is slightly below the share price, but most experienced options traders would describe the strike price and share price as being so close to equal that the option can be labeled as at-the-money.
In this options trading for dummies guide, we covered options trading terms and definitions. Once you get comfortable with options trading 101 basics, you will want to learn one of the most powerful options trading strategies, the covered call.
The covered call is a strategy almost every shareholder should know. It’s probably one of the simplest, yet most powerful of all options trading strategies, and has the potential to produce a consistent income for you.
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