Section 6

Introduction to Options Trading

An option is a contract that gives the buyer the non-binding right to buy or sell an underlying stock at a definitive price prior to, or on a certain date. The only variants of options are calls and puts. A “call” option is the right to purchase 100 shares of a stock at a specified price, whereas a “put” option is the right to sell 100 shares of a stock at a specified price. Investors typically would buy a ‘call’ when they think the stock will go up in value within a certain period of time. Conversely, when investors buy a ‘put’ option, they are betting on the stock decreasing in price by the specified date. You may also exercise your contracts before the expiration if you’re “in the money”, giving the holder the ability to cash out on 100 shares at that strike price. One option represents 100 shares of stock.

Stock option trades are based on calls and puts. You can even invest with a combination of the two, and profit on the margins between the two. A call represents the stock price going up, and a put represents the stock price going down. So when you think call, think positive, and when you think put think negative. 

The strike price of a contract is the price a stock may be purchased or sold for. In order for the contract to get exercised for the stock, it must hit the target strike price before the expiration date. Otherwise, it can be traded just like a share of stock, and profit can be captured on daily fluctuations in price. However, if the stock price does not meet the strike price of an option by the vesting date, the contract expires worthless. In this situation, an investor would lose his entire investment in the option contract, and is why option trading must be done with meticulous care and research.

The option premium is the market price of the option contract. Personal investors typically trade options with the goal of profiting from fluctuations in the premium of an option contract.

The breakeven price shows you where the stock needs to be in order to exercise the contract for a profit. For example, if the strike price for your contract is $100, and it cost $3.20 to buy, the breakeven price is calculated by adding your contract cost to the strike price ($3.20+$100=$103.20).

Thus, the price of the stock would need to be $103.20 for one to exercise the call option and purchase 100 shares of the stock and break even on the investment. However, it is unlikely that personal investors will exercise the contract right and purchase 100 shares. Despite this, there is still profit to be made with options, as the value of the contracts themselves change with the stock price, and could show significant growth even with a smaller growth in the stock price. 

The spread between the bid/ask prices of a contract can be an indicator of the strength of the investment. When the spread is too wide, it is usually a good sign to stay away, as it could lead to trouble exiting a position at a desired price. Identifying trades with a narrow spread will help bump up your odds for a successful trade.A wide spread is usually the result of low volume. Volume is another key indicator when trading options. A commonly arising issue when trading securities with low volume is that it becomes harder to exit a position at a desired price. With regards to options, you may not be able to sell your contract, and it will just end up expiring worthless if you do not have the capital to exercise it. It is key to make sure the contract you want to purchase has a suitable volume, this will ensure that you can get in and out with no problem.

In the beginning, it is easy to confuse volume and open interest, as the two are similar. Volume is the total number of buys and sells in a given period. Open interest is a little different. It’s the total of all the buys or all the sells, but not the total of both.

Think about it this way, you can’t buy something unless there is a seller. In order for a contract to exist, it had to have a buyer. This relationship between the buyer and the seller forms one contract. Remember, one contract represents 100 shares of the underlying stock.

What does this exactly mean?

If you take a look at open interest on the call side, you can see the different levels buyers are looking at. Vice-versa on the put side open interest shows you the different levels sellers are at.

Implied Volatility plays a big role when talking about what affects option contract prices. It is the market’s forecast of how the likely price of the security will change, yet it does not forecast the direction of the change. Ultimately, it tells you what other investors think of the future price movement. This is measured in percentages, and the higher it is, the more investors think the price will move significantly. 

A higher IV causes a high demand for specific contracts and premium prices to rise. 

When looking at IV, you could picture it as a health bar.

Consistent upward movement causes Call premiums to go up.

Turns and rejections damage IV because they disrupt its upward momentum and increase the uncertainty of direction. This is called IV contraction

This causes the premium price to be worth less even though the stock is at the same price where it got rejected. 

The stock price must move higher or strong price action must occur for IV to recover (IV expansion), and the premium price to go higher. 

On the other side, the same forces are applied with Put premiums

Importance of IV

IV is important because it helps you gauge market expectancy. 

Options traders must be aware of buying high IV options because their premium price could get damaged significantly if it goes towards the other direction.

When combined with other risk management metrics, you could effectively decide whether the contract is worth buying, or wait for the IV to get damage and get in at a better price 

Prior to the company’s news events such as quarterly earnings give contracts a higher IV. 

This is because of the expectation of significant changes in stock prices after releasing their stats. 

However, after it’s announced the IV gets crushed. The expectation of price movement not being as high anymore hurts IV. This causes the premium’s price to get crushed with the IV. 

Even with movement that goes your way, an IV Crush could still make you lose money.

Usually, when people see the “Greeks”, they look the other way because they seem so complicated. This is not necessarily the case, as the Greeks are easier to comprehend if you take the time to break them down and understand them fundamentally, as with anything. The Greeks offer multiple risk perspectives for traders to factor in when deciding if the position is worth the risk. Theta, Delta, Gamma, Rho, and Vega are the primary influences that determine the price of an option contract. The “Black-Scholes Model” formula and the greeks are a partial derivative of the options pricing model.

(a) Theta

Theta measures the time decay of an option contract. It portrays the rate of price decline of an option as time passes by. Even if the stock consolidates, the option’s value decreases as time crunches closer to the expiration date. For reference, if theta is .12, the value of the option decreases by $12 per day until the expiration date. 

(b) Delta

Delta calculates the extent to which an option is vulnerable to shifts in the price of a commodity or underlying security. The spectrum ranges from 1.0 to –1.0.

Delta basically just tells you how much an option contract will go up in price relative to the stock price moving $1. (e.g. a delta of 0.75=$75 gain on contract per dollar gain in stock price)

Like the other “Greeks”, the delta is subject to shifts based on the stock’s direction, and how close the holder is to being “in the money”. Delta will not be held at a constant rate and is subject to change, given changes in IV.

(c)  Gamma

The gamma measure of an option determines the rate of change for the delta of the same contract. Gamma is portrayed as a percentage and displays the shifts in delta in acknowledgment of a one-point movement or subtle movement of the underlying asset.

Gamma is frequently changing because of the delta. It will usually hit its peak when it is closest to the strike price target; however, the option decreases the deeper it goes into or out of the money. The further away from the strike price, the closer the gamma value will be to 0. 

(E.g. Suppose for a stock XYZ, currently trading at $65, there is a JUN $70 call option selling for $4, and let’s assume it has a delta of 0.6 and a gamma of 0.3 or 30 percent. If the stock price moves up by $1 to $66, then the delta will be adjusted upwards by 30 percent from 0.6 to 0.9.

On the other hand, if the stock shifts downwards by $1 to $64, then delta will devalue by 30 percent to 0.3.)

(d) Vega

Vega expresses the option’s sensitivity towards implied volatility. Investors tend to confuse this with volatility which is an expected change of value in the future. Vega is the change in option price per 1% change in implied volatility. 

We’ll give you an example to make this more clear to you.

Let’s say an option is worth $5.50 with an implied volatility of 30% and a vega of .15. We’ll assume that the volatility increased 1.5%, expanding the implied volatility from 30% to 31.5%. This increases the option price by multiplying the volatility increase and the vega and adding that to the contract price

[ (volatility increase) x (vega) ] + option price = new contract price

1.5 x .15 = .225 + 5.5 = 5.725 

Now let’s say the volatility drops from 30% to 27%, making volatility decrease 3%. We multiply this with vega and subtract it from the option price.

[ (volatility decrease) x (vega) ] – option price = new contract price

-3 x .15 = -.45 + 5.5 = 5.05

Vega is usually the highest when the option is near its strike price and declines as it approaches the expiration date. 

(e) Rho

Rho measures the option’s sensitivity towards a change in interest rates. This is another factor that must be taken into account in order to have successful risk management with option trading. Let’s say for example the option contract has a rho of 3.0, then for every 1% increase in interest rates, the value of the option or portfolio will go up 3%.

Assume a call option has a strike price of 6$ and the rho is 0.2. If the risk-free rate rises 1%, say from 2 percent to 3 percent, the option call value would rise from 6$ to $6.20. Rho works vice versa with ‘puts’, longer expirations along with options that are near, or in-the-money are more susceptible to changes in interest rates. Contracts that are in-the-money have a higher rho, and drops persistently as the contract shifts to become out-of-the-money. Rho may also increase as expiration time increases.

It doesn’t have to be complicated

We are here to guide you with your path to financial independency. Fulfilling our goal for you to come out more knowledgable and develop a good foundation of investing. Opportunities present themselves everyday, make sure you take advantage of them.