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Preface
Let’s face it, you probably thought options trading is too complex and you should stay away
from it. Moreover, when one of the most famous investors you know says options are danger-
ous, it made you not want to trade them; Warren Buffett, the Oracle of Omaha, said, “In our
view, derivatives are financial weapons of mass destruction, carrying dangers that, while now
latent, are potentially lethal.”
Derivatives is far too general a term to use to describe securities. For example, derivatives in-
clude options, futures, futures options, commodity options, swaps, and swaptions, just to name a
few. Due to Buffett’s quote and the 2008 financial crisis, the term derivatives often has a negative
connotation and many think they are just tools for speculation invented by physicists and mathe-
maticians. However, that’s not the case.
Options are considered a type of derivative because they derive their value from the value of
another asset, also known as the underlying.
Options are actually not that difficult once you understand the basics. What if we told you that
you don’t actually need to understand all the math and physics behind options?
Well, you actually don’t need a background in math, physics, mathematical finance or financial
engineering to trade options. What if you could learn how to trade options over the next 30 days?
Well, you can.
That doesn’t mean you’ll magically become an options guru over the next 30 days. It takes time,
dedication and grit to learn how to trade options. Before you start thinking about different types
of options strategies and how you could potentially use them to better your trading, you need to
understand the basics.
The first 30 days of learning how to trade options are crucial. You shouldn’t feel so overwhelmed
that you have to give up. Rather, you should start with the basics and gradually build upon your
solid foundation.
That said, let’s get right into the swing of things and learn about options trading. In no particular
order, we’ll discuss:
●● “Greeks”
●● Implied Volatility
●● Put-call parity
Don’t worry if you don’t know what any of this means yet, we’ll be going over it in detail. By the
time you finish reading, you should have a strong foundation for integrating options trading into
your own repertoire.
Calls vs Puts
An option contract is simply an option to buy or sell an underlying asset. There are options on
a plethora of assets, such as commodities, indices, futures contracts, stocks, and interest rates.
Although there are various types of options, we will be sticking with stock options, or equity
options.
Quite simply, an equity option contract is a decision about whether you want to buy or sell a stock
at a specified price, on or before a specific date; it’s not different from any other options we have
in life.
There’s one thing you need to know when trading options. If you buy an options contract, your
maximum loss is limited to the amount of premium paid. On the other hand, when you sell short,
or “write”, an options contract, you would receive an initial credit. However, when you write call
options, your risk is theoretically unlimited. If you write put options, the losses can be substantial.
This is one of the reasons why we focus on buying options, and not writing them without hedging
our position.
A call option gives you the right to buy an underlying stock at a specified strike price, on or
before an expiration date. Conversely, a put option gives you the right to sell an underlying
stock at a pre-determined strike price on or before the specified expiration date. When you buy
1 call option or 1 put option, you pay a premium to receive the right to buy or sell 100 shares of an
underlying stock, respectively, and you’re not “obligated” to do so.
That said, the amount of premium you paid is the maximum amount you could lose. However, if
you hold an options contract and it expires “in the money” you would be automatically exercised
on that option. Therefore, you need to make sure you have enough capital in your account to buy
or sell shares of the underlying if you plan on holding options until the expiration date. Generally,
we will exit our positions before the expiration because we don’t want to take the risk of buying
or selling the stock when we’ve already taken large profits or small losses on the options trades.
In order to receive the right, but not the obligation, to buy or sell the underlying stock at a spec-
ified price any time on or before the expiration date, the owner pays the seller, or writer, the op-
tion premium. If you buy a call option, and the underlying stock increase significantly, the owner
of the call option would have unrealized profits. On the other hand, the writer of the call option
would suffer.
Now, the writer of an options contract takes the opposite side of risk and receives a premium.
However, the writer of an options contract is obligated to deliver shares of the security if they are
exercised, or if the options contract expires in the money.
Again if you write options, you would receive a premium for taking on the risk. If you sell short,
or write, a call option, you are obligated to sell shares of the underlying stock if the call option
holder exercises the option, or if the option expires in the money. If you write a put option, you
are obligated to purchase shares of the underlying stock, if the put option expires in the money
or the holder exercises the option.
Keep in mind that naked writing options, or selling without hedging the options, is extremely risky.
You shouldn’t look to write options when you’re first starting out. Moreover, you’re going to need
some collateral if you’re looking to write options to collect premiums.
For example, let’s assume you write a naked call option with a strike price of $50 expiring 1 week
from today and received a credit of $1. The day before the option expires, there’s a press release
indicating the stock is in merger talks and the stock pops to $70. Well, if the stock closes around
that level on the expiration date, you’ll feel some pain. Basically, you would have to sell 100
shares of the stock at $50, while it’s trading around $70. If you cover right at $70, you would lose
$1,900 ($2,000 loss from covering the short position and $100 credit for writing the option).
Now that you understand some of the basics of options, let’s look at contract specifications.
Options derive their value from the underlying asset. Again, there are various options out there, but
we’re focused on stock options. Just for reference, index options are cash settled and some multi-
ple of the underlying index’s value. The underlying asset of futures options is a futures contract. The
underlying of stock options is a specified number of shares of the stock, which is typically 100.
Next, the strike price, or exercise price, is the price at which the option owner could buy or sell
the underlying stock. Remember, if you own a call option, you have the right to buy 100 shares
of the stock at the strike price. Conversely, if you own a put option, you have the right to sell 100
shares of the underlying at the strike price.
Options are said to be “wasting assets” because it has an expiration date. Think of it as a gallon
of milk. If it expires, it’s pretty much useless and you toss it. For example, if you own a call option
with a strike price of $55 and the stock closes at $50 on the expiration date, it doesn’t make
sense to exercise your option and the option would be worthless.
There’s also a notion of exercise style. Options could be American and European. Don’t get
confused, it doesn’t have to do with where you live. American options could be exercised on or
before the expiration date at a given time on any trading day during the option’s life. On the other
hand, European options could only be exercised on the expiration date.
In general, if you have a brokerage account with TD Ameritrade, E*Trade, Interactive Brokers or
any other popular options broker, you’re probably trading American options.
Now, we’ll be using thinkorswim for examples. It’s offered by TD Ameritrade and is one of the most
widely used retail brokers. Later on, we’ll discuss how to select an options broker and platform.
The options chain shows the bid price and ask price, as well as the strike and expiration date, you
could also customize it to show the sensitivities, or greeks, too.
Now, let’s assume you saw Apple Inc. (AAPL) report strong earnings and you thought once it
broke above $200, it could continue higher. You decide to buy 1 AAPL 17 AUG 18 200 Call. That
means you’re buying 1 call option contract on AAPL expiring on August 17. Well, you could see
that it’s $3.95 bid x $4 ask, and you’re willing to pay the nickel spread and you take the ask, or
Above, you’ll see a graph known as your risk profile. Basically, it shows your profit and loss at
expiration, depending on where the stock is trading in relation to the strike price. In this example,
you wouldn’t start making money until AAPL broke above $204. Why’s that? Remember how you
already paid for the options. That money is already spent, but that doesn’t mean you can’t sell it
and take a small loss, rather than your entire premium if the stock isn’t going your way. Again, if
AAPL closed below $200 on August 17 (the expiration date), you would lose your entire premium
if you held onto them.
Assume a trader was actually bearish on AAPL and believed it would pull back once it reached
$200. Well, if the stock actually closed below $196, he would make money. The trader paid $400
for one $200 strike price put option on AAPL. If AAPL actually closed above $200, their option
would be worthless.
You should have a basic understanding of the difference between call options and put options.
Before we start looking at ways to use put options, you’ll need to understand how options are
priced. We won’t be using any fancy math here, we’re just going to let you know what factors
affect an option’s price.
Now, just because it’s your second day learning about options, that doesn’t mean you should go
out and open an options account right away. Study this and understand what’s actually going on.
Options Pricing
How Options Are Priced
There are many options pricing models out there. However, options pricing is a course in itself.
You’re going to need a lot of math and a bit of physics to understand the theory behind options
pricing. However, don’t be scared. We’re going to focus on the basics here and look at the factors
affecting an option’s value.
Now, there are three major factors affecting stock option prices:
●● Volatility
●● Dividends
Keep in mind that interest rates would matter if they’re constantly changing. That said, let’s take a
look at how these factors affect an option’s price.
Volatility
Volatility is the underlying stock’s tendency to fluctuate in price. This means volatility reflects the
price change’s magnitude and does not have a bias toward price movement in one direction
or another. You need to understand that the higher the volatility, the higher the option premium
should be. The lower the volatility, the lower the premium.
Interest Rates
Generally, interest rates do not affect premiums as much as the time value, the underlying stock
price, and volatility. However, when interest rates experience a high degree of fluctuations, rates
matter. An increase in interest rates typically increases call prices and decreases put prices,
based on the famous Black-Scholes pricing model. There are flaws with this model, but it’s an
industry standard. However, we won’t get into all the details of this pricing model.
Dividends
Options are often priced assuming they would only be exercised on the expiration date. That
means if a stock issues a dividend, the call options could be discounted by as much as the divi-
dend amount. However, put options would be more expensive since the stock price should drop
by the dividend amount after the ex-dividend date.
Before you move on, you should clearly understand these factors and how they affect option
prices. Next, we’re going to look at an extremely important topic: intrinsic and extrinsic value.
The intrinsic value simply tells us the amount an option should be worth when comparing the un-
derlying stock’s price and the strike price. Let’s use the Apple (AAPL) example from earlier. Apple
was trading around $200 and assume you bought 1 call option expiring in two weeks. The op-
tions give you the right to buy the stock at $200. Assume Apple ran to $210 and there’s still one
week until the expiration date. That said, your option should be worth at least $10, or $1,000.
As you can see, when the stock was trading at $210, your PnL was $608, so the options were
worth $1,000 ($608 + $400 (the amount of premium paid)).
Arbitrageurs tend to eat those profits before you even get a chance to do any of that.
Now, if an option has not expired yet, it also has extrinsic value. The extrinsic value is an option
value’s component, reflecting the fact the option has optionality. For example, let’s continue
with our AAPL option example. If AAPL is trading at $200, the $195 put options do not have any
intrinsic value. You definitely do not want to exercise the option to sell AAPL shares at $195 when
they’re trading at $200, that’s an instant loss. However, if the puts have enough time until its
expiration date, it could still have some value. This is because there is some probability that AAPL
could trade below $195. If the stock drops to $190, the puts would become in-the-money (ITM)
and have an intrinsic value of $10.
That said, extrinsic value reflects the value of owning the option because its intrinsic value could
increase in the future.
Put-Call Parity
Put-call parity is a highly important relationship between puts and calls. Fundamentally, puts and
calls are the same thing. Put-call parity applies to only put and call options with the same strike
price and expiration date. Let’s take a look at the payoff diagrams of calls and puts to understand
this important detail.
If you recall the put option and call option PnL diagrams from the AAPL example, you’ll notice
how there’s some symmetry.
If the underlying stock is trading at $210, the $200 calls have $10 of intrinsic value, while the puts
will have no intrinsic value. Conversely, if the underlying stock is trading at $190, the $200 put
options would have $10 of intrinsic value, while the call options would be “worthless”. Keep in
mind we’re considering these values on the expiration date.
The beauty of options is you could synthetically create various strategies with different call and
put options. Continuing from the Apple example earlier, it’s possible to synthetically create a sim-
ilar payoff profile of the $200 call options, using the $200 puts and the underlying stock. All you
need to do is simply hedge the $200 strike price puts with the underlying stock, and let’s assume
the stock is at $200. Here, we would create a synthetic $200 call option. The same could be
done to create put options with calls and the underlying stock.
This is a very important detail for options traders. Basically, the only difference in a call option’s
value and a put option’s value with the same strike price and expiration date is the intrinsic value.
For example, if AAPL was trading at $210, and you owned $200 call options, you take the differ-
ence between $210 and $200 and find the maximum. But once you get the hang of things you
can do this simple math pretty quickly.
If you recall, an option’s value has two components. Well, the extrinsic value is the remainder of
the option’s value once you’ve figured out the intrinsic value. Due to the put-call parity, put and
call options with the same strike, expiration, and volatility should be worth the same, in terms of
extrinsic value. However, that’s not always the case in the markets. Sometimes, you’ll see put op-
tions that are more expensive than calls, and vice versa, even though everything else is equal.
Now that we’ve gone over the factors affecting an option’s value, let’s look at some reasons why
traders use options and how you could potentially incorporate this into your trading.
Some other ways to express your bullish or bearish opinions would be to write puts or calls,
respectively. Now, these are extremely dangerous and we don’t suggest beginners go out and
write options. We cannot stress this enough, when you naked write, or short options, you have a
high degree of risk. What happens if you write put options because you’re extremely bullish on
a stock, but the company goes bankrupt? Well, those put options would be really expensive and
you’ll have to deliver those shares and potentially receive a margin call. You never want to get a
margin call whatsoever because that means you’re not properly managing your trades.
You see, you never know how far a stock could move. Consequently, writing options without be-
ing hedged is extremely dangerous and you should stray away from it when you’re first learning
to trade options.
In this case, if the underlying stock price rises, you would profit by owning the stock, but you
would lose the premium paid for the put. That said, could be used to alter your risk profile of a
stock or portfolio to fit your needs.
Remember the call option PnL diagram at expiration? Well, here’s how your position would look if
you’re long 1 SQ 24 AUG 18 $66 put option and 100 shares of the underlying at $66.
This strategy relies on the fact that some options have extrinsic value, which will be gone by the
time the options expire. So, the idea here is that by selling options, the fall in value, also known as
time decay, or theta decay, could be captured for a profit. Even though the extrinsic value will fall
as the option gets closer to its expiration, or maturity, date, the intrinsic value could still rise.
Let’s take a look at an example. We’ll go over the covered call strategy here. A covered call strat-
egy is comprised of a long stock position and a short call position.
Now, if you own a stock, you could enhance your returns by selling out-of-the-money call options
on the underlying stock. If the stock price falls, you would lose money, but the calls will expire
worthless and you would minimize your losses because you collected that premium. For example,
here’s a look at a covered call strategy.
Take this SQ example. Assume you’re long 100 shares of the stock, but don’t think it can get
above $75.
On the flip side, if the stock rallies and continues to make highs, you would profit from the rise
in the stock’s value. However, you would lose money on the short call position. Theoretically, a
call option has unlimited upside potential because it’s nearly impossible to predict where a stock
could go. Since you are hedged with the position, if you are exercised on those options, you
would still profit, which would be equivalent to the strike price of the call option less the purchase
price of the stock. There’s a tradeoff here. What if the stock is in buyout talks and it rises 40%,
well your upside is limited. Your maximum loss would be limited to the price you paid for the
stock less the premium you received if the stock starts to drop below the strike.
Volatility is often viewed as an asset class. There are various derivatives out there that offer ex-
posure to volatility, such as variance and volatility swaps and swaptions. However, we won’t be
looking at these complex derivatives, we’re only focused on equity options here.
Since volatility impacts nearly all trading strategies, it’s becoming increasingly important for
traders to manage that risk or capitalize on changes in the level of volatility. Volatility is one of the
most important factors of an option’s value, and we’ll leave you with a simple strategy.
Let’s assume you think a stock is going to move significantly after its earnings announcement, but
you don’t know in which direction. Well, you could put a straddle on, which is a play on volatility.
Basically, you’re purchasing an at-the-money call option and an at-the-money put option. In other
words, if the stock is trading at $65, you would purchase a $65 call option and a $65 put option
on an expiration date after its earnings.
Here’s a look at an example. SQ was trading around $65 before its earnings announcement. You
think the stock could move in either direction a lot over the next few weeks, so you decide to buy
an at-the-money straddle expiring 3 weeks from its earnings date.
You should understand the different ways to use options. Now, let’s take a look at some basic
strategies to get you started.
Basic bullish strategies include long call and protective put. Some intermediate to advanced strat-
egies include: collar and long call spread and back spread with calls.
On the other hand, some bearish strategies include: long put, long put spread and back spread
with puts.
Well, what if you’re not sure about the direction but think the underlying stock can move a lot.
You could either buy a straddle or a strangle. Now, we won’t be focused too much on neutral
trades here because we feel directional option trades is where the money is at.
Long Call
If you recall, we’ve already gone over some examples of a long call and married put, or protective
put. It’s quite clear if you’re bullish on a stock, you could buy shares outright. However, options
provide leverage and you can always potentially make more if you hit the sweet spot.
For a call option, you typically want to buy them when the stock is at or above your selected
strike price. Now, it’ll take some experience to determine which strike price is best, depending on
the stock. Some choose at-the-money, while others may want to buy in-the-money or out-of-the-
money options.
Now, your break-even point at expiration is the strike price plus the premium paid. The sweet
spot here is if the stock explodes. Your max profit potential is theoretically unlimited. A stock
could continue running up endlessly, but we haven’t seen that yet. Calls serve as an alternative
to buying shares of the stock outright. Keep in mind you shouldn’t go nuts with the leverage. If
you’re comfortable with trading only 100 shares, then stick with 1 call option contract. However,
if you’re comfortable and could afford to trade 1,000 shares of the underlying, maybe you could
buy 5 to 10 call options.
Just to refresh your memory, here’s a look at the profit and loss (PnL) diagram of a call option
contract.
Protective Put
The protective, or married, put is another bullish options strategy. You may want to use a protec-
tive put if you’re bullish but nervous the stock could pull back before running higher. If you own
the underlying stock, you could hedge your position by buying a put at a specified strike price.
In general, the stock price would be above the strike price. When you purchase a protective put,
you have the right to sell the shares you already own at the selected strike price. You could use
protective puts as an alternative to stop orders because sometimes those orders don’t get filled.
Your break-even price at expiration is the current stock price plus the premium paid for the put.
Now, your maximum potential profit is theoretically unlimited because you would still own the
stock if it runs higher. On the other hand, your risk is limited to the current stock price minus the
strike price plus the premium paid.
Now, keep in mind, for both of these basic bullish strategies, time decay is the enemy and will neg-
atively affect the value of the options since you’re long. We’ll go over time decay on a later day.
The collar is best suited for those who are bullish but a bit anxious about the stock falling. The
setup for a collar involves a long position in the underlying stock, a put option at a specified strike
price X and a short call option at a specified strike price Y. For this strategy, the stock price would
be between strikes X and Y, and the strike price X is less than strike price Y.
Since you’re buying a put option, you have the right to sell the stock at strike price X. Additionally,
since you sold a call option, you would be obligated to sell the stock at strike price Y if the option
is signed.
Think of a collar as combining a covered call with a protective put. Now, the covered call is simply
a long position in the stock and a short position in a call option at a strike price above the stock
price.
With a collar, you have limited downside risk. However, you have limited upside potential. There
are two break-even points for a collar strategy. If you implement this trade for a net credit, the
break-even is the current underlying’s price less the net credit received. On the other hand, if the
trade is implemented for a net debit, the break-even point is the current stock price plus the net
debit paid.
In order to hit your maximum profit potential, you would want the stock price to rise above strike
price Y. Now, the maximum potential profit is limited to strike price Y less the current stock price
less the net debit paid, or plus the net credit received. Your maximum potential loss is limited to
the current stock price less strike price X plus the net debit paid, or less the net credit received.
With this strategy, you have the right to buy the stock at strike price X and you are obligated to
sell the underlying stock at strike price Y if you are assigned. If you’re bullish on a stock and have
an upside target, this strategy may be suited for outlook.
Your break-even price at expiration is strike price X plus the net debit paid. Now, in order to reach
your maximum profit potential, you want the underlying stock’s price to be at or above strike
price Y on the expiration date. However, you probably don’t want to see the stock way above the
strike price because you’ll be kicking yourself thinking, “Why didn’t I just buy a call option?”
Now, your maximum potential loss is limited to the net debit paid.
If you could implement this strategy for a net credit, that’s ideal. If you’re wrong on the trade and
the stock actually falls, you could still potentially make a small profit. This all depends on the expi-
ration date, the selected strike prices and the volatility of the stock.
Your break-even points if you implement the trade for a net credit is strike price X plus the net
credit received or strike price Y plus the maximum loss potential, which is strike price Y less strike
price A less the net credit received, or plus the net debit paid). Here, your profit potential is theo-
retically unlimited.
You don’t want the stock to trade around $67 - $68 because that’s where you would be close to
your maximum loss on this trade.
Now that you got a taste of some bullish strategies, let’s look on the flip side.
Long Put
Now, you’ve already seen this strategy earlier. This is the simplest bearish strategy. You would
buy a put option if you’re bearish on a stock. Puts are great as an alternative to short selling a
stock. When you short a stock, you’re exposed to unlimited risk, theoretically, because you simply
don’t know where the stock could go. On the other hand, when you buy a put option, the maxi-
mum potential loss is just the premium paid.
The maximum profit potential here is if the stock goes to zero. Your profit would be equal to the
strike price less the premium paid. However, you should keep in mind that it’s rare for stocks to
go to zero. So don’t think that once the stock drops 10 to 20% that it could go to 0.
Basically, you want to see the stock fall below the strike price less the premium paid.
To implement a long put spread, you would just buy a put with strike price X and sell a put with
strike price Y. Generally, the stock price will be at or below strike price Y and above strike price X.
With this strategy, you have the right to sell the stock at strike price Y and you are obligated to buy
the underlying stock at strike price X, if you are assigned.
Your break-even price at expiration is strike price X minus the net debit paid. To reach your max-
imum profit potential, the underlying stock’s price needs to be at or below strike price X on the
expiration date. The maximum profit potential is capped at the difference between strike price X
and strike price Y less the net debit paid.
Now, your maximum potential loss is limited to the net debit paid.
You would sell a put at strike price Y and buy two puts with strike price X. The stock price should
be at or around strike price Y if and when you implement this trade.
If you implement the strategy for a net debit, your break-even price is strike price X less the maxi-
mum risk, or strike price Y less strike price X plus the net debit paid.
On the other hand, if this trade is established for a net credit, you have two break-even points.
The first break-even point here is strike price X less the maximum risk. The second break-even
point is strike price Y less the net credit received. With this strategy, you want the stock to plum-
met. If the stock tanks, there is large upside potential.
Let’s assume Square (SQ) is trading at $65 and you think the stock could drop. Now, you sell an
at-the-money put expiring in 2 weeks for $3.50 and you buy 2 OTM puts with a strike price of $62
with the same expiration date.
You should have a good foundation of bullish and bearish options strategies by now. Keep in mind
these aren’t all the options strategies out there. However, it should give you a good tool belt de-
pending on your outlook on a stock.
Strategies with
an Unknown Outlook
What if you don’t know what a stock is going to do? Well, there are strategies for that too. Some
strategies that you could implement if you don’t have conviction about whether a stock is going
to go up or down include straddle and strangle.
Straddle
You may have heard someone say, “The at-the-money straddle is priced correctly”. Many traders like
to buy straddles into an earnings event, or another potentially volatile corporate event. Basically, a
straddle gives you the best of both worlds if you think a stock could move a lot in either direction.
If you recall, you would just buy a call and a put with the same strike price and expiration date,
and generally the stock should be near the strike price.
Another strategy that you might implement if you don’t know where a stock is headed, you could
buy a strangle.
A strangle is very similar to a straddle. However, you would buy a put option at strike X and a call
option at strike Y. The stock should be between those two strike prices.
Basically, with this strategy, you’re anticipating a swing in stock price, but you’re not sure which
direction it will go.
Take a look at the PnL diagram above. The stock is currently trading around $65. Now, you buy
1 SQ $60 24 AUG 18 put for $1.75 and 1 SQ $70 24 AUG 18 call for $1.95. Therefore, you spent a
total of $3.70, or $370.
With this strategy, you either want the stock to go to the moon, or tank and get flushed.
Theoretically, your PnL is unlimited. This happens if the stock just rages and continues going
higher. Again, we haven’t seen a stock go to infinity, so this is all in theory.
If the stock goes down, your profit potential could be substantial, but it’s limited to strike X minus
the net debit paid.
If and when you throw this strategy on, you really want implied volatility to increase. An increase
in implied volatility will increase the value of both options, and it also suggests an increased pos-
sibility of a price swing.
On the other hand, a decrease in implied volatility will be painful because it will work against both
options you bought.
Synthetic Options
One aspect of options trading to understand is synthetic options. You can use options to syn-
thetically create positions. That’s the beauty of options. If you want a risk profile similar to that of
a stock, you can synthetically create this using options. You can create a long stock position by
simply buying a call option and selling a put option. Here’s a look at the risk profile of a long call
and short put.
You can do the same to implement a synthetic short stock position. You would need to buy a put
option and sell a call option to create a synthetic short stock position.
Now, you could also create a synthetic call option or put option with stock and options. For exam-
ple, if you recall, the protective put looks a lot like the call option. This is considered a synthetic
call option.
Now, that you know some strategies, let’s take a look at some important factors about implied
volatility.
Remember, there are several factors affecting an option’s price including the underlying stock’s
current price in relation to the strike price and time value. The others (dividends and interest
rates) are not as important. Another important factor is the implied volatility of the underlying
stock over the option’s life.
For out-of-the-money (OTM) options to be worth anything, there has to be some probability that
it could expire in-the-money. If there’s no chance a stock could expire in the money, there’s really
no point to trade options minus the fact that they help to leverage your capital. That said, the
underlying stock needs to have some price volatility. In other words, the stock’s price needs to
move in order for the option to become valuable.
Generally speaking, the more volatile the stock, the more valuable the option on that stock would
be. It doesn’t matter whether it’s a put or call. For example, before an earnings announcement,
the level of implied volatility tends to be higher. This is due to the fact that earnings announce-
ments are hard to predict and there tends to be a high degree of price volatility after a stock
releases earnings.
Due to the fact that you could uniquely identify an option’s value with one level of expected, or
implied, volatility, the option value inherently implies the expected volatility level.
In order to calculate an option’s value, the factors affecting an option’s price are plugged into
a pricing model. The way options work, you would need to work in reverse and start with the
option value and all the other factors except the expected volatility. All you would need to do is
rearrange the formula and make the expected volatility level the point. Good thing we have trad-
ing platforms that do all that for you.
These options expire on August 17, while SQ reports earnings on August 1. Therefore, the option’s
life includes the earnings date. If you look at the options chain, you’ll notice a column that says
“Impl Vol”. This is short for implied volatility and you should see a percentage term.
One way to interpret implied volatility is by looking at expected standard deviation, or volatility, in
the underlying stock price for the upcoming year. Now, standard deviation is simply the dispersion
of the stock prices.
Take SQ for example, assume an at-the-money option expiring in one year has an implied volatility
of approximately 60%. You could interpret this as: Over the next year, the options market expects
the stock to move 60% in either direction.
There are a lot of assumptions behind the implied volatility. In the example, we use an option expir-
ing in one year. Well, you might be wondering, Could I use the implied volatility for one month? You
can’t really do this in practice. Sticking with the same example, the implied volatility used to price
the option, even though it’s an annualized figure, it really only relates to the expected volatility
over the option’s life. That in mind, it would not make sense for you to use the implied volatility for
one month if the option is expiring in one year. The one month implied volatility does not really tell
you anything about an option expiring in one year’s time.
Keep in mind, you must be careful if you’re converting an implied volatility into a stock’s expected
range one year from now. It’s possible to compare implied volatilities across different stocks and
stock indices because implied volatility is quoted in percentage terms, and therefore, it’s indepen-
dent of the underlying stock price or index level.
Let’s take a look at how you could convert the annual volatility level. This is quite simple to do.
Converting the annualized implied volatility into a daily number is simple. All you would need to
do is divide the implied volatility by the square root of a time frame. For instance, if you want to
figure out what the options market is implying about the stock’s price movement in one month,
you would divide the annualized figure by the square root of 12, since there are 12 months in a
year. For example, let’s assume the annual implied volatility of SQ $66 24 AUG 18 call options is
around 60%.
That means you would expect those options to have a monthly volatility of 17.32%.
That means the options market is expecting a 3.78% move for that specific strike price and expira-
tion date.
Now, if you multiply this by SQ’s current stock price, it gives you a rough estimate of SQ’s daily
move in terms of dollars and cents. This gives you an idea of theoretical prices changes in the
underlying stock that the options are currently pricing in.
Some traders will quote options in implied volatility terms. In addition to interpreting implied
volatility as the underlying stock’s standard deviation, implied volatility could be viewed as the
option’s price.
The implied volatility is uniquely mapped to the option value. Remember, higher implied volatility
means higher option prices, and you could use these interchangeably. Options traders like to use
implied volatility to quote an option’s value because there’s an edge over an option’s dollar value.
Remember, there are three main components of an option’s value, and the underlying stock price
is one of them. In dollar terms, an option’s value is highly sensitive to the underlying stock price.
The delta is simply an option’s sensitivity to the underlying stock price, which we will discuss
more in detail the next day. For example, if a call option has a delta of $1, for every $1 move up
the option would gain $1. However, if the underlying moves down $1, then the call would lose $1.
To volatility traders, the intrinsic value is just noise, which is driven by the underlying stock price.
It really doesn’t tell them about the option’s value that is due to the extrinsic value.
Just know that the dollar value of an option is sensitive to the price change in the underlying. In
other words, if you’re long a call option and the option value increased, but the implied volatility
remained the same, you know the increase is due to the fact the intrinsic value increased.
Since we’ve got a good idea of what implied volatility is, let’s look at what affects implied volatility.
If traders want to buy options, the option would be bid up, causing a rise in prices and implied
volatility will follow suit.
Now, what drives supply and demand? Well, it’s hard to say. Supply and demand for options could
depend on trader sentiment. It could also depend on the implied vol level.
For example, let’s assume a stock’s volatility is below the implied vol in the options market.
Assume the company is expected to make a big announcement soon. The demand for options
would be high due to the uncertainty of what the company might say, regardless of the current
actual vol level. What if the company has a press release and the stock price runs up after?
Now, what typically happens is the implied vol will fall sharply. We see this with earnings releases
all the time. Implied vol runs up into earnings, then wham. The vol gets sucked out after because
there’s no more uncertainty. The demand for options falls, and there’s an oversupply of those
contracts because traders may be looking to liquidate their options.
Remember, one way to use options would be to hedge your stock position. Now, the higher the
degree of uncertainty over the future stock price volatility, the greater the demand for options as
hedges. This leads to higher prices and implied vol.
For example, if a stock’s price has an annual historical volatility of 30%, and it’s done that every
year, more or less, over the last decade. Then it’s probably a good estimate that the implied vol
this year would be 30%, all else being equal.
However, what happens if implied vol for a specific options contract, say the call options, is 60%.
Well, something is up. If this is the case, clearly someone knows something or has high expecta-
tions the stock could run up.
Over the longer run, there’s a low probability that implied vol and historical vol will significantly
diverge in one direction. Now, quick and large changes in actual vol levels should impact implied
vol. Again, since realized vol tends to cluster, implied vol does too. That said, implied vol is likely
to resemble historic vol. Now, if you notice large discrepancies between the two different vola-
tilities, there could be a trading opportunity or reflect some new information that could affect the
underlying stock price that you might not have seen before.
Take note that the traders could be wrong about implied vol. Everyone has an opinion, but the
market doesn’t care about opinions, sometimes.
●● You should have a basic grasp of implied volatility now. That said, let’s move onto the
greeks.
Greeks
(Delta and Gamma)
Greeks are used to measure different factors affecting an option’s value. These include Delta,
Gamma, Theta, Vega and Rho. However, we won’t be going over Rho because it just measures
how sensitive an option is in relation to changes in interest rates. It’s generally not a huge factor
and typically considered only when interest rates are changing. All you need to know is Rho mea-
sures the expected change in an option’s price per 1% move in the risk-free rate.
Delta
Delta measures how much an option’s value is expected to change for every $1 move in the un-
derlying stock. We touched on this earlier.
Call options have a positive delta and it ranges from 0 to 1. Generally, at-the-money options have
deltas close to 0.50. As you look through the options change, the deeper you go in the money,
the higher the delta. The delta for deep in the money options will approach 1. Moreover, as we
approach the expiration date, the delta of in the money call options will approach $1. As an option
is deeper in the money, it more or less behaves like a stock. On the other hand, as we approach
the expiration date, out-of-the-money call options will approach zero.
On the flip side, put options have a negative delta, ranging from -1 to 0. Basically, just think of
what we said for call options, but with negative values. At-the-money put options typically have a
delta near -0.50. As the option goes deeper in the money, delta approaches -1. As we go farther
out of the money and approach expiration, the delta of those options approaches 0.
Gamma
The next greek is gamma. Gamma measures the sensitivity of an option’s delta for every $1
change in the underlying stock. Basically, gamma lets you know how much an option’s delta
should change as the underlying stock price changes.
There’s one thing to note about delta, it’s simply a snapshot. It’s only accurate at a specific time
and price. When an underlying stock moves, the delta changes. Since delta can’t exceed -1 or +1,
gamma decreases as the option gets further in the money.
If you look at the options chain on AAPL, the $182.50 strike price calls have a gamma of 0.02.
That means for every $1 change in the stock price, the delta would chain by 0.02.
Greeks
(Theta and Vega)
The next greek is theta. Theta measures the sensitivity of an option’s price for a one-day de-
crease in its time to expiration. Theta lets you how much the price of an option should decrease
as the option nears expiration. When you’re long options, theta, or time decay, is your worst ene-
my. On the other hand, if you’re short options, theta is your best friend.
Options lose value as their expiration approaches, theta estimates how much value the option
will lose each day if all other factors remain the same.
Since options are non-linear, the theta of ATM, just slightly OTM and ITM options generally in-
crease as expiration approaches. On the other hand, theta of deep out-of-the-money options
generally decreases as expiration approaches.
If you look at the options chain again, you’ll see the theta values.
If you look at the ATM options, or $190 strike price calls and puts, the theta is -0.15. That means as
each day passes, the options would lose $0.15 in value, all else being equal. This could be helpful
when you’re selecting options to potentially trade.
Vega
Vega is not a Greek letter, but it’s still important to understand. Vega measures the rate of change
in an option’s price for every 1% change in the implied volatility of the underlying stock. Essen-
tially, it tells you how much an option’s price should move when the volatility of the underlying
security or index increases or decreases.
Let’s look at the $172.50 strike price calls and puts. These are at-the-money since FB was trading
around $172.50. The calls and puts have a vega of 0.07. That means for every 1% change in the
level of implied volatility, the options would fluctuate by $0.07.
If you neglect vega, you could potentially “overpay” when buying options. All else being equal,
when determining strategy, you should consider buying options when vega is below “normal” lev-
els and selling options when vega is above “normal” levels. One way to determine this is to com-
pare the historical volatility to the implied volatility. Most options platforms allow you to do this.
A decrease in vega will typically cause both calls and puts to lose value. On the other hand, an
increase in vega will typically drive the prices of calls and puts higher.
You should have a basic understanding of the greeks now. However, you’ll need to study this
over and over for it to actually become intuitive. Moreover, if you have access to an options plat-
form, that’s even better.
For example, an option that trades around 100 contracts per day will be much more difficult to
trade than options that trade say 5,000 contracts per day. In other words, try to find options that
are traded frequently.
For example, if you’re trading something like AAPL, you could clearly see this is a liquid name.
Open interest is another important factor to take into account. Open interest lets you know the
number of contracts held in a specific option. Open interest measures market activity. If there’s
little to no open interest, that means there aren’t really any traders or investors opening posi-
tions, or nearly all the positions have been closed. If there’s a high open interest, it means there
are many contracts still open, which means market participants will be watching those options
closely.
If you’re looking for options to trade, you need to look at the volume and open interest. Generally,
you’ll want to trade options with a lot of contracts traded and a relatively high open interest.
Bid/Ask Prices
The next thing you need to look at before you enter an options trade is the spread. The spread is
basically the difference between the bid price and ask price. When you’re buying options, you’re
bidding for it. On the other hand, if you’re selling options, you post on the ask side and offer the
contracts.
Just like when you’re trading stocks, you only want to trade stocks with a tight bid-ask spread.
For example, if you see a specific options contract with a bid price of $1.25 and an ask price of
$3.25, you probably don’t want to trade those options.
On the other hand, let’s say you see a specific options market with a nickel spread. You’ll want to
trade those instead because prices are more competitive.
You’ll notice the market is fairly wide. Let’s say you wanted to trade at-the-money calls when the
stock is trading at $45.75, expiring 2 weeks from today. Those options were $1.80 bid x $2.20
ask. These options at 40 cents wide. Let’s say you just lift the offer at $2.20, you just paid up over
$20 for that because you probably could have bought them for cheaper.
Notice a difference?
FB has a higher trading volume for these strikes and a higher open interest. Look at the bid-ask
prices now. The bid-ask spread is tight.
Basically, the more an option trades and the greater the open interest, the tighter the bid-ask
spread.
For example, one of the gurus at RagingBull noticed TripAdvisor (TRIP) had a nice run up after its
earnings release. However, he didn’t want to chase the stock up 10 points. He noticed the stock
was consolidating and could potentially run up after the 13-period simple moving average broke
above the 30-period simple moving average on the hourly chart.
Since the stock was trading around $50, he looked to buy at-the-money options. The $50 15 JUN
18 were $1.25 x $1.45. Now, the way to enter this trade would be to try to get in closer to the bid
or mid-market.
Basically, you would click on trade and set a price you’re willing to buy the options contract at.
The trader was looking to get filled closer to the bid, so he placed a limit order to buy.
Now, let’s assume you’re trading options on large- or mega-cap stock. These options are liquid
and if you’re willing to pay the spread you can just take the offer.
For example, let’s assume you think Facebook Inc. (FB) is still a strong stock and has a chance to
rebound. Well, you look to buy call options. Let’s assume based on your analysis, FB could rally
back to $200.
Assume the current price of FB is $175.76, so you look to buy at-the-money call options. These
are $2.49 x $2.52. Those options expire 2 weeks from today.
What if you didn’t know where the stock was headed? Well, if you recall, you could use a strad-
dle. This is pretty easy to do as well.
Above, you’ll see the order entry box to buy an at-the-money straddle. The calls cost $2.52
apiece, while the puts cost $1.66 apiece.
Now, you should have an understanding of how to enter orders. That said, let’s take a look at
some options brokers.
The only way you’ll force yourself to learn is to be held accountable. If you open an options
account and even put the bare minimum in, it’s almost like shorting an option. You’re obligated to
learn because you have some skin in the game. However, if you don’t open an options account,
you’re probably less inclined to study this material.
Before you even start trading options, you’ll need to select the right broker. There are a lot of bro-
kers out there, but you need to find a trusted one with all the necessary tools. Remember, don’t
just go out an open an options account and throw on trades for the heck of it. You should see
how options work and use some of the knowledge you’ve learned to use options platforms.
TD Ameritrade
Many retail traders use TD Ameritrade to trade options. It’s easy to use and traders can trade
from pretty much anywhere. TD Ameritrade does not charge any platform fees and there aren’t
any trade minimums. Moreover, its pricing is straightforward and costs $6.95 per options trade
and 75 cents per contract. Keep in mind those are the fees when you trade on the app or plat-
form. If you use a broker or its Interactive Voice Response (IVR) phone system, it would cost
$44.99 per trade and 75 cents per contract, and $34.99 and 75 cents per contract, respectively.
Now, this is a trusted broker, but just because a lot of traders and investors use it, it doesn’t
necessarily mean you should use it. Make sure it actually has everything you want. Remember,
you need to conduct your own due diligence and see if this platform and broker offer the needed
tools. Additionally, you should be okay with paying these trading fees.
E*Trade
E*Trade is another widely-used broker for trading options. There are even some gurus at Raging
Bull using this platform. For options, it offers a web platform and OptionsHouse. There are a pleth-
ora of tools to help with options trading. For example, you can find potential opportunities easily.
Again, be sure to do your own due diligence if you’re looking to pick E*Trade as your broker.
Now, Interactive Brokers offers various products. Here’s why some traders opt for this.
●● Client Portal – This tool is suitable for new clients, traders and investors who want an
easy way to trade with 24/7 access. You’re able to check quotes, place trades, view
account balances, P&L and performance metrics.
●● IBKR Mobile – You could easily trade and monitor your options on the go from your iOS
or Android device.
This platform provides research, news, market data, real-time monitoring, algos and trading tools,
and risk management, just to name a few.
Some other notable options trading brokers include Charles Schwab, TradeStation, Robinhood,
and Tradier.
Again, you need to figure out which options broker is best suited for you. Not all people like the
same things. However, most beginners opt for TD Ameritrade or E*Trade because they’re both
easy to use and have a professional feel.
Keep in mind, opening an options account doesn’t mean you could just trade options right away.
Again, once you open an options account, just watch and observe for a little while and use this
book as a guide to examine options. Some platforms, like TD Ameritrade, will allow you to pa-
per trade to get comfortable first. That means you don’t have to put real money on the line yet.
However, trading with paper money is a lot different from trading real money. When there’s real
money on the line, you have skin in the game and you’ll probably be glued to your positions more
than when you’re using paper money.
What Now?
Looking Forward
On this last day, you should go back and review the material and any notes you’ve taken. Trading
options is going to be a little difficult at first. You might be overwhelmed, but you should have a
good foundation now. It’s time to put your knowledge to the test. However, you should be look-
ing to trade with a community that focuses on options. When you trade with like-minded traders,
you’re able to ask questions. For example, what if you thought a stock could rise, but you didn’t
know which options to buy? Someone in the community might chime in.
Again, study this material and know it like the back of your hand over the next 30 days. You can
even paper trade and test some of the strategies in this book, calculate the implied volatility and
look at greeks. Basically, over the next 30 days, it’s about building intuition. You don’t need all
that math and physics to be a great options trader. In fact, some of the best options traders take a
simple approach.
For example, maybe you want to paper trade straddles ahead of earnings. You’ll find something
very interesting. You might end up losing money on the paper trade because there’s something
known as the vol crush. Basically, there’s no more uncertainty after an earnings announcement.
Maybe you notice a bullish chart pattern, and think it could run higher. You could paper trade a
call option and see what happens. Basically, you need to get good at entering orders, looking at
options chains and developing as an options trader.
Well, there you have it. 30 days worth of education that should put you well on your way to being
an “options master” now. I hope you study and put these into practice.
If you want to go from simple “education” and learn 20 years worth of “wisdom”, then I encour-
age you to join my Weekly Money Multiplier service.
Weekly Money Multiplier is the single best resource you can have for navigating the options
market week to week. Learn from me every day and elevate your trading game to the next level.
I look forward to working with you on your journey this year!