Options trading involves a fair amount of risk, especially if you aren’t too familiar with the ins and outs of stock trading in general. Option trading can be fairly speculative and carry substantial risk of loss. I recommend only trading options if you have risk capital you are okay with potentially losing. Options are very versatile and have a lot of different strategies and ways you can trade them.
What Are Options?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell a stock at a specific price on or before a certain date. An option is a binding contract with strictly defined terms and properties. The versatility in options comes into play in many different facets, for example, you could buy an option and sell that same option within the same day, you could also let the option expire at which point the option becomes worthless and you lose 100% of your investment. We will explain some of these strategies in further detail throughout this article. Options are called derivatives, which basically means an option gets its value from something else. For example, you buy an option contract for $2.00 per contract from AAPL. This contract is dependent on AAPL stock prices and relies on the price of the stock to move the price of the contract you bought.
Calls and Puts
There are two types of options, they are called “calls” and “puts”. Think of these like you would when trading stocks. If you think the price of a stock will increase you are going “long”, in options, that is considered a “call”. If you think the price of a stock will decrease you are going “short”, in options, that is considered a “put”. There are a multitude of different strategies and ways you can trade calls and puts on the stock market. I recommend for those starting out stick to either playing a long call or a short put until you understand the volatility and the ins and outs of playing options.
When you begin trading options you will quickly notice there are a lot of terms you may be unfamiliar with coming from stock trading. We will go over the most important ones so you have a clear understanding of what they mean once you start trading.
The strike price is the price the stock can be purchased or sold at, this price you will pick before executing the order. Dependent on the stock these could be in varying increments dependent on the stock, most are usually in $1, $2.50, $5 increments. This generally is the price you think the stock will get to. If you are trading options and not investing in them long term, the stock price does not need to reach or exceed your set strike price before you can execute a sell, however if it does exceed your set strike price you more than likely will be looking at a profit.
This one is fairly simple to understand, when trading options you will also need to select your expiration before executing a trade. This expiration is set based off when you think the stock will reach or exceed your strike price. Most stocks have Weekly and Monthly expiration you can choose from. Keep in mind the sooner you pick the expiration the cheaper it is but the quicker you will see time decay from your option, which we will get into later. Conversely the farther out you select your expiration the more expensive your contracts are and the slower you will see time decay.
ITM, ATM, OTM
You probably are looking at these abbreviations and wondering what in the world they mean, lets break them down. In this example we will be going over these abbreviations based off if you bought call options. ITM (In The Money) means the price of the stock is above the strike price you selected when you executed your order. ATM (At The Money) means the price of the stock is at the strike price you selected when you executed your order. OTM (Out of The Money) means the price of the stock is below the strike price you selected when you executed your order.
Implied volatility is heavily used when trading options and is one of the main indicators to look at when trading. Implied volatility is only an estimate of future prices rather than an indication of them. Higher implied volatility means a large price swing, but it doesn’t indicate which direction that price swing is, could be high or low. Low volatility usually means the price won’t make broad, unpredictable changes. One of the main strategies people use is trying to buy call options when volatility is low and buy put options when volatility is high. The thought behind this is, generally the option price is cheaper when volatility is low, this presents call buyers the opportunity to get in at a lower price. The opposite is true for put option buyers, they want to buy when volatility is high because as volatility lowers put contracts increase and call contracts decrease.
The Greeks in options trading show the different types of risk variables within trading that option. Being able to understand and interpret the Greeks can help you make a smart decision when executing an option order. You will see why they are called “The Greeks” in a moment.
Delta represents the rate of change between the option price and a $1 change in the stocks price. So for example, say you buy an option contract for $1.00 per contract and the delta on that option contract is .50, that means that if the stock price increases $1 then your option contract will increase by .50. So if the stock increases $1, your contracts that you bought for $1 are now worth $1.50 and you have made a 50% profit.
Theta represents the rate of change between an option and time. This one is regularly called “Time Decay” and something we touched on earlier. In my opinion, theta is one of the most important things you should look at and understand prior to buying an option. Theta indicates how much an option’s price would decrease as the time to expiration decreases. For example, say you buy an option contract for $2.00 per contract and the theta on that option is .50. This means that every day that passes the option price would decrease by .50, all things being equal. So say, the stock price doesn’t change for 2 days, the theta would drop the option contract price .50 per day. So now your option contracts that you bought 2 days ago for $2 each are now worth $1 each, and you are looking at a 50% loss.
Gamma represents the rate of change between an options delta and the stock price. Gamma essentially indicates the amount the delta would change given a $1 move in the stock price. For example, you bought an option contract for $1 per contract. The Delta on that is .50 and the gamma is .15. So, if the stock price increases $1, the options delta would move from .50 to .65.
Vega represents the rate of change between an options value and the stocks volatility. Vega indicates the amount an option’s price changes given a 1% change in implied volatility. For example, if you see the Vega is .15 that indicates the options value will change by 15 cents if the implied volatility changes by 1%.
Rho represents the rate of change between an option’s value and a 1% change in the interest rate. For example, if the option contract you are buying has a Rho of .05 and a price of $1. If interest rates rise by 1%, the value of your option would increase from $1 to $1.05.
I hope you were able to learn a lot from this article and get a better understanding of how options work and understand the lingo that is associated with it. Options can fluctuate in price rapidly, it is highly recommended that you educate yourself and have a full understanding of options before starting to trade them. As always, feel free to leave a comment below or reach out if you have any thoughts or questions and I will be glad to assist you further.