Options 101

How to become a successful options trader:

  •  Paper trade for 3-6 months before trading real options
  • Dont trade short term expirations(risky and greed kills a trader)
  • Must have a exit strategy
  • Do free options trading courses on CBOE website and on our site
  • Focus on a few strategies
  • Learn unusual options block trading(we have lots of posts in our options volume blog)
  • Learn what pinning prices around options expirations week
  • How to calculate strangle prices
  • Learn how to read charts for entry exits(we have lots of free analysis in our site and premium trade alerts)
  • Dont trade into the earnings

 Why trade Options:

  • IT WORKS WITH STOCKS
  • IT TAKES LESS CAPITAL THAN STOCKS
  • LEVERAGE ABLE
  • CHOSE YOUR OWN RISK LEVELS!
  • MORE WAYS TO WIN THAN TRADING STOCKS
  • RISK MANAGEMENT WITH MULTIPLE STRATEGIES

What is Options:

  • Stock Options are derivative instruments just like stock futures. Stock Options costs only very little money to buy while allowing you to control the profits on the underlying stocks as if you owned those stocks! It is very similar to the Option to Purchase you signed when you bought your house. If the price of the stock rallies strongly after you purchase its stock options, you would make those same profits without buying the stocks at all! This creates the big gains that you hear  from the Options Traders.
  • In Options Trading, we are not trading the stocks itself. Instead, we are merely trading the right to own or sell those stocks and these contracts to buy or sell the underlying stocks are known as stock options.
  • A stock option is just  a contract between  2 parties in which the stock option buyer (holder) purchases the right(but not the obligation) to buy sell 100 shares of an underlying stocks at a pre determined price from/to the options seller(writer) within a fixed period of time.
  • One side is a buyer-One party bets that one is going up ( call options buyers)
  • Another side a seller-Another part is betting that is will go down (seller)
  • You can take either side
  • Agree on a price (mid price)
  • the options is created

 

How Call Options Work:

When you choose a call option, you’re paying for the right to buy shares at a certain price within a specified time frame. Consider an example in which shares of Nike (NYSE: NKE) are selling for $90 in July. If you think that the price will increase over the next few months, you could buy a six-month option to purchase 100 shares of Nike by January 31 at $100. You would pay roughly $200 for this call option assuming it costs about $2 per share (remember that you can only buy in 100 share increments when it comes to options), which would in turn give you the option to acquire 100 shares of Nike anytime within the next six months. Compare that to the $9,000 you would have paid had you wanted to buy the shares outright ($90 multiplied by 100 shares) and the difference is significant.

Scenario 1: On December 10, if shares of Nike are trading at $115, you can exercise your call option and net a $1,300 gain (the $15 profit per share multiplied by 100 shares minus the $200 original investment). You could alternatively choose to make a profit by re-selling your option on the open market to another investor. This will often lead to a similar gain.

Scenario 2: If, however, Nike’s share prices fell and never reached $100 during the six-month period, you could just let the option expire and save your money. Your only loss would be the original $200 cost.

Risks:

Now, let’s analyze the potential risk of investing in options. First, in Scenario 1 where Nike’s shares never reach $100 and you lose the entire $200 original investment, what was your percentage loss? 100%! As bad a day or year as anyone has had in the market selling stock, you’ll rarely find someone who has incurred a 100% loss. The only way this can happen is if the underlying company went bankrupt and their stock price went to zero.

As you can see, options can lead to huge losses, especially when you analyze it from a percentage point of view. To further illustrate this point, let’s say Nike’s share price was $99 on the last day you could exercise your options. Of course, you wouldn’t exercise them because you would lose a dollar on every share. But what if you had instead invested $9,000 for the actual stock and owned 100 shares. Well, on this day that marked six months out from the original investment, you would have a 10% gain ($99 versus $90). Imagine that: a 100% loss (options) vs. a 10% gain (stock). As you can see, the risks of options can’t be overstated.

To be fair, the opposite is true for the upside. If the stock was trading at higher than $100, you would have a substantially higher percentage gain with options than stock. For example, if the stock was trading at $110, that would imply a 400% gain ($10 gain compared to the original $2 investment per share) for the option investor and a roughly 22% gain for the stock investor ($20 gain compared to the original $90 investment per share).

Lastly, with owning stock, there is nothing ever forcing you to sell. For example, if after six months, the shares of Nike have gone down, you can simply hold onto the stock if you feel like it still has potential. A year later, if it’s gone up drastically, you’ll make a significant gain without ever having incurred any losses. However, had you chosen to invest in options, you simply would have been forced to incur a 100% loss after six months with no choice to hold onto it even if you feel like the stock will go up from there.

Thus, as you can see, there are major pros and cons of options, all of which you need to be keenly aware of before stepping into this exciting investing arena.

How Put Options Work:

A put option is the exact opposite of a call option. This is the option to sell a security at a specified price within a specified time frame. Investors often buy put options as a form of protection in case a stock price drops suddenly or the market drops altogether. Put options give you the ability to sell your shares and protect your investment from sudden market swings. In this sense, put options can be used as a way for hedging your portfolio, or lowering your portfolio’s risk.

In this example, you own 100 shares of Clorox (NYSE: CLX) stock, which you purchased for $50 a share. As of January 31, the stock has gone up to $70 per share. You want to maintain your position in Clorox, but you also want to protect the profits you’ve made, just in case the stock price drops. To fit your needs, you can buy a six-month put option at a strike price of $70 per share.

Scenario 1: If Clorox stock takes a beating over the next few months and falls to $60 per share, you’re protected. You can exercise your put option and still sell your shares for $70 each even though the stock is trading at a significantly lower price. And if you feel confident that Clorox stock will recover, you could hold onto your stock and simply resell your put option, which will surely have gone up in price given the dive that Clorox stock has taken.

Scenario 2: If, on the other hand, shares of Clorox kept climbing, you’d let your option expire and still reap the benefit of the increased value of the shares you own. Yes, you’d lose out on what you invested into the options, but you still haven’t lost the underlying stock. Thus, one way to look at it in this example is that the options are an insurance policy which you may or may not end up using. As a quick side note, you can buy put options even without owning the underlying stock in the same manner as call options. There is no requirement of owning the stock.

Risks:

The exact same risks apply as detailed in the Call Options section above. Buying the put options has the potential for a 100% loss if the stock goes up, but also the potential for huge gain if the stock goes down since you can then resell the options for a significantly higher price.(examples from moneycrashers)

 

Types of Options orders:

Only two option trade positions you can take

  •     Opening positions(buy to open, sell to open)
  •     Closing positions(buy to close, sell to close)
  •     Expressed in short cut BTO.BTC,STO,STC

 

Options terminologies:

Strike Price:

The strike price is defined as the price at which the holder of an options can buy  or sell  the underlying security when the option is exercised. Hence, strike price is also known as exercise price.

 Exercise / Assignment:

Exercise: When an options owner(holder) who invokes their right to buy and sell is said to exercise their option contract at the strike price( note that call option holders exercise their right to buy,put option holders exercise their right to sell)

Assignment:  Assignment takes place when the written option is exercised by the options holder. The options writer(seller) is said to be assigned the obligation to deliver the terms of the options contract.

  • If a call option is assigned, the options writer will have to sell the obligated quantity of the underlying security at the strike price.
  • If a put option is assigned, the options writer will have to buy the obligated quantity of the underlying security at the strike price.

Options Volume : Volume measures the number of contracts that exchanged hands during the trading session (daily). It measures market activity. Volume does not clearly tell you how many went at ask or bid. Typically if Volume> Open interest then options traders consider it as  new volume but you have to check it on the following day in the open interest to confirm it if they were bought or sold.

Open Interest(OI) is the total number of outstanding contracts. Open interest is the settled contracts you see from the previous day at the market open in  Open interest (OI) column.  It gauges market participation.

 

Implied volatility(IV):

Implied volatility (IV) is one of the most important concepts for options traders to understand for two reasons. First, it shows how volatile the market might be in the future. Second, implied volatility can help you calculate probability. This is a critical component of options trading which may be helpful when trying to determine the likelihood of a stock reaching a specific price by a certain time. Keep in mind that while these reasons may assist you when making trading decisions, implied volatility does not provide a forecast with respect to market direction.

Example of Implied volatility: Let’s assume a stock trades at $50 with an implied volatility of 20% for the at-the-money (ATM) options. Statistically, IV is a proxy for standard deviation. If we assume a normal distribution of prices, we can calculate a one standard-deviation move for a stock by multiplying the stock’s price by the implied volatility of the at-the-money options:

One standard deviation move = $50 x 20% = $10

The first standard deviation is $10 above and below the stock’s current price, which means its normal expected range is between $40 and $60.(ALLY)

 

Historical vs. implied volatility:

There are many different types of volatility, but options traders tend to focus on historical and implied volatilities. Historical volatility is the annualized standard deviation of past stock price movements. It measures the daily price changes in the stock over the past year.

In contrast, implied volatility (IV) is derived from an option’s price and shows what the market implies about the stock’s volatility in the future. Implied volatility is one of six inputs used in an options pricing model, but it’s the only one that is not directly observable in the market itself. IV can only be determined by knowing the other five variables and solving for it using a model. Implied volatility acts as a critical surrogate for option value – the higher the IV, the higher the option premium.(ALLY)

 

Options Greeks: ( How one can predict options price)

  • Delta (Greek Symbol δ) – a measure of an option’s sensitivity to changes in the price of the underlying asset

–Delta is the amount an option price is expected to move based on a $1 change in the underlying stock. Calls have positive delta, between 0 and 1. That means if the stock price goes up and no other pricing variables change, the price for the call will go up. Here’s an example. If a call has a delta of .50 and the stock goes up $1, in theory, the price of the call will go up about $.50. If the stock goes down $1, in theory, the price of the call will go down about $.50

  • Gamma (Greek Symbol γ) – a measure of delta’s sensitivity to changes in the price of the underlying asset

–Gamma is the value that measures the sensitivity of the delta value of an option to price movements of the underlying security. The delta value of an option isn’t fixed and it changes as the market conditions change; the gamma value provides an indication of the rate at which the delta value moves in relation to those changes.

  • Vega – a measure of an option’s sensitivity to changes in the volatility of the underlying asset

–Vega indicates how sensitive the price of an option is to changes in the volatility of the underlying security. It’s essentially an indicator of how much the price of an option will move relative to movements in the implied volatility of the underlying security.

–The Vega value is slightly more complex than the previously mentioned Greeks, but it’s something that you should really try and understand as volatility can, and does, play a big role in options trading

Theta (Greek Symbol θ) – Theta measures the exposure of the option price to the passage of time. It measures the rate at which options price, especially in terms of the time value, changes or decreases as the time to expiry is approached.

 

Popular Options strategies:

  •     Bullish Options strategies: Call buying, Covered calls, bull call spread, the collar, bull calendar spread,  naked puts, Covered straddle.
  •    Bearish Strategy: Put buying, bear put spread, covered puts, naked calls.
  •   Neutral strategies:  Iron condor, straddle, strangle, butterfly.

 

Options chain to trade options( Image):

The most important information is shown right at the top and they are usually the underlying security, along with its latest market price, and the expiration month.

Below image of an options chain taken from Internet

  • Calls are usually listed on the left hand side while puts are typically displayed on the right hand side. In-the-money options are usually highlighted to differentiate them from out-of-the-money options.
  • Strike price: Down the middle is the range of strike prices available for trading for the selected expiration month. The strike price intervals vary and depends on the price of the underlying.
  • Last done price: The last done price reflects the latest transacted price for the specific option. As the most recent transaction may be hours or days ago, especially for thinly traded contracts, you should check the bid-ask price rather than the last done price to get a better picture of the current market value of the option you wish to trade.
  • Bid-Ask spread: The bid and ask shows the price at which buyers are willing to pay and sellers are looking to receive for the particular option. The bid-ask spread is the difference between the bid and the ask and the size of the spread depends on the liquidity of the option. As a general rule, the lower the open interest, the wider the bid-ask spread. Furthermore, near the money options usually have higher open interest and hence better liquidity and narrower bid-ask spreads.

Disadvantages of options trading:

1. Time value decay

Unlike stock where you can hold on to it for many years or even passes on to your children, all options have an expiration date. Remembering that options is a “wasting” asset, there is nothing you can do to stop the options from expiring. The rate of time value decay increased over time when the options get closer to the expiration dates. Therefore be sure to watch over your open options position like a hawk and not to let it expired worthless. In options trading you  have to be aware of your time frame and must have a stop loss.

2. Full Loss of Investment

If you hold onto a trade that go against you and the options are out of money at expiration date, you may lost every single cents that you invested in the options. Playing in the money and long term expirations are bit safer but you always need a exit strategy.

3. Unlimited Risk. Some option positions, such as writing uncovered options, are accompanied by unlimited risk. One can limit risks by playing neutral strategies.

Overall Options present a good opportunity to formulate plans which can take advantage of volatility in underlying markets as well as price direction.

 

Price vs Open interest volume(OI):

Example: QQQ chart and  Jan 4th 2019 Options volume analysis:

As you can see below the chart and options chain of weekly  $QQQ  Jan 4th 155 calls strike volume 17000 contracts vs  open Interest volume(OI) 11000 contracts. The day  was eventful as  Job numbers came  out strong also Fed chair Powell announced that fed will be patient with monetary policy. Market interpreted the message positively and Price went up to 156.26$. In this case the event reaction took the $qqq price above the highest OI volume strike 155.  We have to assume that there were some calls volume accumulation into the event also it was an weekly expiration.  Had there not been any events the scenario could have been completely different. This example highlights the events reaction, without the events reaction $QQQ would have expired below 155$.  We highlighted this volume in our social media account on Jan 2nd 2019. Our twitter : www.twitter.com/Stockoption_Edu

 

 

Options Pin/Max pain:

Options pinning is an interesting phenomenon where a stock’s price will move to end on a particular option strike. This can happen only happen on a expiration day The Pinning phenomenon works because big hedge funds and Prop traders have exposure at certain strike prices in the Options markets, and it is in their advantage to see expiry happen very close to these strikes. The way they achieve this is by placing large Buy / Sell orders in the Equity markets and the Futures markets. The orders are large, so these have the ability to “guide” the stock to a certain price by the end of the day. You may see this happen with a strike has considerable open interest, atleast 2x more than any other strikes. However, Pinning does not work every time, especially in volatile markets where lots of fundamental events or news is happening, but in the absence of such market moving events or news, it tends to occur more frequently.

For example, if a stock has options with exercise prices (strike prices) at $100, $102.50 and $105, and there are many option contracts outstanding, the stock is far more likely to close within a few pennies of one of those prices than not. In other words, the theory goes, a closing price of $99.90 – $100.10, or $102.40 – $102.60, or $104.90 – $105.10 is more likely than prices that are farther away from the strikes. If the stock does close very close to a strike price, we say that the stock price has been pinned to the strike.

There is a related idea called the point of maximum pain(max pain). The theory here is that stocks tend to close on option expiration day not only at a strike price, but at that particular strike price at which the total value of all outstanding options, including both puts and calls, is at its minimum. Therefore the owners of options in the aggregate suffer the largest possible loss, and the writers of options as a group enjoy the highest possible profit.