Learning how to trade options adds another dimension to your trading. It’s especially great for those traders who have small accounts. Options are leveraged products, allowing you to reduce capital and manage risk efficiently.
For example, check out this Tesla Trade:
I was able to more than double money on the put options I bought; utilizing leverage and defining my risk.
Now, before I place any options trade, I’ll look at an options chain to see what my choices are. If you’re new to options trading, an option chain can be confusing at first.
What is an options chain?
An options chain gives you information on how much calls and puts cost for every strike price and expiration period. It will tell you how active an option strike is, the last price it’s traded at and what the current bid/ask price is.
Here’s an example:
This image was taken from the Nasdaq website, let’s go through everything starting from left to right.
This is an options chain for Apple calls. These are call options that are out-of-the-money and expire on August 18, 2017.
Now, some options have expiration periods that are weekly as well as monthly. Monthly options typically expire on the 3rd Friday of the month. Near-term options are cheaper than longer-dated options; however, that doesn’t necessarily mean that they are better.
You should select the option expiration period that fits your trade expectations. New option traders assume that “cheap” is good, but cheap options are cheap for a reason. After all, options are wasting assets.
The first strike price is the $155 calls. It last traded at $1.88 per contract. One option contract leverages 100 shares, the total premium for the $155 calls is $188 (1.88 x 100). If the stock closes above $155 on the expiration date, the options expire in the money, and you would be long 100 shares at $155. However, if the stock closes below $155, you would lose the $188 premium.
For this option series, there are strikes that start at $2.50 all the way up to $285. Some option contracts will have strikes that are $0.50 apart while others might be $1, $2.5, or $5 apart. There may even be a difference from one expiration series to the next.
For example, the weekly call options in Apple are $2.5 apart.
Whereas the August monthly options are $5 apart.
Now, the strike price you select will either be near-the-money, out-of-the-money or in-the-money. Options that are out-of-the-money are cheaper but that doesn’t necessarily mean that they are better choices.
An option premium consists of intrinsic value and extrinsic value.
An option’s intrinsic value is the difference between the option’s strike price and the current market price of the stock.
If Apple is trading at $150.27, the $145 calls are $5.27 in-the-money. That said, the option premium for these call options is $6.88.
The option $5.27 in intrinsic value and $1.61 in extrinsic value.
At expiration, an option only has intrinsic value. That’s why extrinsic value is also referred to as time value.
Out-of-the-money and at-the-money options only have time value.
This is simply the last price that was filled for the option strike. For example, the last price filled on the $155 calls was $1.88.
How can this information be useful?
You can get an idea of how liquid the options are. For example, the bid/ask for the $155 calls is $1.84 by $1.88 and the last trade in the option strike was $1.88.
What if the last price was $3?
That would be an indication that the options aren’t that active since the bid/ask spread is $1.84 by $1.88.
Also, the last price gives us an indication if there are buyers or sellers in the options. For example, the last price is $1.88 and that is what the options are offered out at, an indication that the last trade was a buyer.
Traders are bidding $1.84 per contract and are offering out at $1.88. The spread on these options is only $0.04. You want to try to trade options that have a competitive bid/ask spread. Wide spreads that give up a lot in terms of slippage.
Volume & Open Interest
The volume tells you how many options have traded during the trading day. The $155 calls traded 10,815 contracts. Now, any position that is still open will get transferred over to the open interest. The open interest for the $155 calls is 39,103 contracts. The next trading day we’ll find out how much that open interest changes. For example, if 10,815 contracts were closing positions, then the open interest would be reduced to 28,288. Open interest is updated at the start of each trading day.
Execution is important, stick with trading options that offer competitive bid/ask spreads. Looking at the volume and open interest can also be helpful. You want to avoid options that have little volume and open interest.
Select an expiration period that matches your market opinion. For example, if you’re playing for a catalyst that is happening in a week, then you don’t need to go out and buy options that are three months out.
At expiration, an option will either expire in-the-money or expire worthless. In-the-money options are are better choices when you have a strong directional opinion. Knowing your way around an options chain can help you make better decisions when it comes to your options trading.
Jeff Bishop is lead trader at TopStockPicks.com. He runs short-term trading strategies, using stocks, options and leveraged ETFs.