Introduction to Trading Approaches

Just like a professional athlete would not approach their sport without a plan for how to perform, Option traders who want to be successful need a game plan. This game plan has three elements: selecting a trading approach, selecting a trading style and selecting the right option strategies. In this part of the Beginner’s Guide to options trading, we’ll consider the first element, the trading approach.

Options give traders powerful tools to seek out trading opportunities in any market condition. The two different types of options, calls and puts, provide traders an opportunity to benefit from either rising or falling stock prices. But there is also an alternative to buying call or put options. An option trader can choose to approach option trading as a seller, rather than a buyer.

Option buyers purchase a chance to either buy a stock or sell it short, but option sellers look for a chance to capture the price of the option itself. This approach is quite different from speculation of price movement and represents its own set of challenges and opportunities. Option traders should learn how both option buying and selling approaches work.

The difference between the two approaches is a difference in probability. It’s true that option buyers can come across big opportunities, but the probabilities built into option pricing formulas actually favor option sellers.

That’s because buyers always face the same two challenges on every trade: a built-in expiration date and time decay. Sellers face a different challenge: the risk that the stock may move strongly in favor of the buyer.

Let’s take a closer look at the pros and cons of these two approaches.

First consider the benefits of being an option buyer: big opportunity and limited risk.

As an option buyer, you get to hunt down big opportunities. You may not always get the timing right on an option trade, but if you do, the opportunity for unusually large returns does exist. The challenge of being a buyer is that option prices are usually set in such a way that buyers have a lower probability of winning their trades than losing them.

The second benefit is that you can clearly define how much you will risk and keep your losses limited to that amount. When you have a losing trade, the amount of money you put into the trade represents the total amount you have at risk.

The benefits of being an option seller are different. Sellers get favorable pricing and probability in comparison to option buyers. But it comes at a cost.

The first benefit of being a seller is that you get to collect time value instead of paying for it.
Since time decay happens every day, option sellers benefit from that daily dynamic. If the stock price does not move strongly in the option buyer’s favor, then time decay ensures that the seller will be more likely to see their position benefit.

The second benefit is that option sellers don’t need to have excellent timing. Options are priced to favor the sellers, because sellers set the price in a way that covers most of their risk. The price of an option reflects what sellers expect to see happen with the stock. If they expect the stock price to move strongly against them, they set the price of the option higher. This market action means sellers are more likely to be successful every day the stock closes without big moves in the buyer’s favor. That is why sellers have a higher frequency of opportunities for good trade setups.

It’s also true that each decision comes with tradeoffs. For example, those who buy options have the potential for a big opportunity, while those who sell options give up that potential in exchange for smaller, more frequent opportunities.

Another tradeoff has to do with how much an option trader must risk. The premium a buyer pays represents their entire risk of the trade. However, sellers take on much more risk in exchange for the premium they collect. That’s because when a trade goes against a seller, the losses aren’t limited to the cost of the option premium collected, but the potential profits are.

A good rule of thumb is that option buyers will experience less frequent opportunities but have correspondingly larger trade setups compared to the risks. By comparison, option sellers will experience more frequent opportunities but take correspondingly larger risks compared to the cost of the trade.

These pros and cons tend to balance out in such a way that neither side has much mathematical advantage over the other. However once a trader has chosen an approach, they also have to select a trading style and option strategies that are likely to work well for them. Both of those elements are discussed in the next parts of the guide.

How to Read Option Prices

Reading option prices takes a bit of getting used to, but even beginners find that it doesn’t take long to catch on to what they are seeing. Without being able to read option prices accurately, option traders might not clearly understand what they are getting into, or how much money they might put at risk.

This part of the beginners’ guide will help you get a basic understanding of how to read option prices from a broker’s quote screen. Keep in mind that the illustrated examples are hypothetical prices only. Option prices are usually displayed in a format that looks something like this illustration:

This is what is known as an option chain. It is a table of prices that organizes options by strike price and expiration date so buyers can locate the exact option they need. It is important to understand that the data in the option chain is interrelated. The following illustration will identify each of the six most important elements an option buyer would need to know. Let’s walk through these elements one by one.

1. The current stock price
   This price fluctuates as the stock price rises and falls. On broker’s platforms, the option prices will change in real time as they adjust to any changes in the stock price. It is important to understand that the option prices you are looking at in the option chain are always based on the last published price of the stock.
2. The expiration date of these options
   Brokers platforms will show a separate table of option prices for each available expiration date that options are offered. New groups of options with a new expiration date are created as previous groups expire.
3. The option type (whether call or put) Calls give the right to buy, puts the right to sell. Calls are always listed on the left side of the table and puts are always listed on the right.
4. The strike price of each available option
   This is the price where an option buyer has the chance to own shares (calls) or sell them short (puts). The more heavily traded a stock is, the greater the number of different strike prices that are likely to be available for option traders.
5. The bid and ask prices for each option
   When a trader wants to buy an option, they look at these prices. The example here is the 100 strike price, and if a trader wanted to buy that option, they would usually have to pay the ask price. In this example the price is 5.00 per share. Since option contracts usually include 100 shares of the stock, the price for this option is $500. If the buyer wanted to sell the option immediately after buying it, they would need to accept the bid price. In this example that price is $4.90, so buying the option at $5.00 and selling it at $4.90 represents a ten-cent transaction cost. When that ten cents is multiplied by one hundred shares, it amounts to a difference of ten dollars. This transaction cost is in addition to any commissions the broker might charge. 
6. The Strike price closest to the current price of the stock
   In this example, the $100 strike price is the closest to the last traded stock price. This particular option is referred to as being “at the money.” Option traders look for the at-the-money option when they want the most efficient balance between cost and leverage.

In addition to the state of being at the money (ATM), options can be either considered “in the money” (ITM) or “out of the money” (OTM). Calls are in the money when they have a strike price below the current price of the stock and puts are in the money when they have strike prices above the current price of the stock.

The state of being in the money comes from the value a trader gets if they choose to exercise their contractual rights. Call option buyers have a contractual right to buy the stock, so a strike price below the current price means they can get the stock for below market rates. On the other hand, put option buyers have the right to sell stock. So if a put option trader can initiate a short sale on the stock with a strike price that is higher than current market price of the stock, then that put option is in the money. The illustration previously shown labels the options in each of the following states.

ITM:
The options in the shaded area are in-the-money because they have value if exercised at the current stock price. As the stock price rises enough to cross through strike prices, these strikes become ITM. Put options become ITM when stock prices fall below the strike price. All option data providers will highlight these options.

OTM:
The options not shaded are out-of-the-money because these options have no value if they are exercised at the current stock price. Call options become OTM if the stock price falls below the strike price. Put options become OTM if the stock price rises above the strike price.

ATM:
This is the strike price closest to the current price of the stock. Note that this option may also either be ITM or OTM. In this case, the 100 strike price is ITM for calls and OTM for puts. This option more sensitive to stock price moves than any OTM options, but less expensive than any of the ITM options.

Option contracts are created and sold by market makers in response to demand. When these options are created, the market maker sets the price. Changes in an option’s price are driven by the normal market action of buyers and sellers, but also by movement of the stock price and the perception of investors. Market makers are constantly publishing new bid and ask prices for all of the option contracts they offer. They compete with other market makers and this competition is good for option buyers because it creates more efficient pricing on the option chains.

The difference between what buyers pay to secure their contractual rights and what sellers get when entering into the contract is known as the bid/ask spread. The size of the gap between the bid and ask prices is not the same for every option. Generally this size of this gap is affected by two things:

1. ITM or OTM. The bid/ask spread is tighter for OTM strike prices than OTM ones.
2. The liquidity of the option. More popular and heavily traded options have tighter spreads, while less popular and less liquid options have wider spreads. Compare the example of the hypothetical prices for XYZ options (previously shown) and ZYX options (following illustration).

In this hypothetical example of an option chain for ZYX stock, the prices are depicted as what might be typical for a stock which is less popular and therefore less liquid than XYZ stock. The option chain looks very similar except for two things:

1. The bid/ask spread for each contract is much wider. This wider bid/ask spread is an indicator that fewer option traders have chosen to speculate on price moves in ZYX stock.
2. The gap between the strike prices is also further apart indicating a lack of trader interest in ZYX stock compared to XYZ stock.

Watching the gap between the bid and ask prices and the strike prices is a useful detail for a trader to notice. As either of these widens, the transaction costs for these options increases adding additional risk to the trade.

There is a lot more to learn about what can be read from option prices, and brokers include additional information beyond that captured in these examples. For further study on what else can be learned from reading option price data, be sure to review this article: “Reading Options Quote Information.”

Being able to accurately review option price information helps a trader more effectively approach the market as either a buyer or a seller of options. The next part of the Beginners Guide introduces the concept of trading approach and helps explain why traders might approach option trading in different ways.

Option trading is structured to allow traders and investors the ability to leverage their money. This makes options a more effective instrument for investors to hedge or protect large stock positions they may be holding. That same leverage also makes it possible for options to be used as tools for speculation. The growing sophistication of the option market allows traders to access many different trading strategies. This wide array of strategies can be confusing to beginning option traders, so it is helpful to divide the strategies into categories.

The three categories discussed in the previous part of the Beginners Guide will help explain what each of the trading strategies is most commonly used for and what a trader needs to learn to be able to use these strategies well. There is a lot to learn about each trading strategy, but for now, the following information will simply introduce you to the ideas behind these strategies. We’ll divide these explanations into three categories: 

1. Delta trading, for emphasizing leverage opportunity
2. Theta trading, for emphasizing income opportunity, 
3. Gamma trading, for emphasizing speculation opportunity. 

Delta Trading Strategies

Delta trading strategies are those which help traders leverage their trading capital so that they can protect existing stock positions, or so that they can speculate on price movements.

The two most commonly used option trading strategies are the most straightforward ones: buying a call option, or buying a put option. Buying a call option leverages an upward move in the price of a stock, while buying a put option leverages a downward move.

However, these straightforward trading strategies have the challenge of time decay. Option prices lose value over time, so effective delta trading strategies need to overcome that challenge. Here are the four most commonly used delta trading strategies that overcome time decay.

1. Buying in-the-money call or put options
2. Buying vertical spreads 
3. Buying calendar spreads
4. Buying diagonal spreads

Theta Trading Strategies

Theta trading strategies help traders generate income opportunities because they rely on the most consistent aspect of option pricing: time decay. Theta-style strategies try to help a trader benefit from the time decay by taking the approach of selling options rather than buying them. 

If you buy an option, some of what you pay for includes the amount of time left before the option expires. So it stands to reason that if you sell an option, you are collecting the value of that time. Theta strategies emphasize the collection of that time value. Here are the most commonly used theta trading strategies that seek to collect time decay.

1. Selling covered calls
2. Selling out-of-the-money call or put options
3. Selling vertical spreads
4. Selling Iron Condors

Gamma Trading Strategies

Gamma trading strategies are those that traders would consider if they are seeking to capture highly speculative moves that represent larger opportunities than other strategies. Gamma trading strategies tend to be more effective when they emphasize time frames that are closer to the expiration date.  That’s because options with more time left to expiration have lower gamma scores. 

Traders who seek to capture speculative moves also like to limit their risk to relatively lower starting prices in their option trades. Here are the most commonly used gamma trading strategies that seek to emphasize speculation opportunities

1. Buying out-of-the money call or put options
2. Buying call or put options with less than three weeks to expiration
3. Buying out-of-the-money diagonal spreads
4. Day-trading options one or two days before expiration

There are many more strategies that can be classified into these three styles of trading. It is important to know the emphasis for each option trading strategy. No matter how complex an option trading strategy can become, it usually has the emphasis of one of the three trading styles.

It is also important to know that not all option trading strategies are available to the beginning option trader. Brokers allow different levels of trading authority based on a trader’s profile of available funds, investing horizon and experience in the markets. To learn more about how a trader acquires option trading authority from a broker, be sure to check out the next part of the Beginners Guide.