Now, before you read this, understand that some of you will never reach this level of options mastery. That’s okay because you don’t need to, but it sure does help if you one day want to trade complex strategies like straddles, iron condors, and even spreads.
Option trading gives traders choices; they aren’t tied down to just making directional bets. With options you can implement several strategies that work when:
- For or against extreme price moves (in one direction, or both up and down)
- Stocks are range-bound
- Stock Volatility is rising or falling
- The Market Reaches a Specific Range or Not Reaching a Specific Price or Range
- A Combination of These Things Occurring
Bottom line, you can paint whatever picture you want…however, it also makes it trickier trade than trading stocks. For example, if you buy shares of stock…you’ll make money if the stock price rises and lose if it drops.
However, with options, the price is not the only factor.
The Price of an Option is a Function of These Factors
- The risk-free interest rate
- The stock dividend
- The strike price of the option
- The movements in the underlying stock price
- The volatility of the underlying futures price
- Time till expiration
By plugging all these inputs, you can get a theoretical option price. Now, this is just an estimate of what the option should be valued at
The traders in the market determine the actual price of an option. After all, the cost of an option is only worth what someone is willing to pay for it.
Option Premium: Intrinsic Value + Extrinsic Value
Intrinsic Value: What the option would be worth if today were the expiration day.
Extrinsic Value: The probability and time component in the option value.
In-the-money options: intrinsic value + extrinsic value
At-the-money options: Extrinsic Value only
Out-the-money options: Extrinsic Value only
For a more detailed example, check out this article on strike price.
Options are time decaying instruments. As an option gets closer to expiration the time premium in those options starts to wither away. At expiration the option is only left with its intrinsic value.
Quick Example: XYZ stock is at $100 per share.
The $95 call: $7.90 ($5 of intrinsic value + $2.90 of extrinsic value)
The $100 call: $5.00 ($0 of intrinsic value + $5.00 of extrinsic value)
The $105 call: $1.90 ($0 of intrinsic value + $1.90 of extrinsic value)
Options Trading – Advanced Topics – Option Greeks
Delta: this is how much directional bias the option or position has.
Call Options have a positive Delta; Put Options have a negative Delta.
The deeper ITM the option is…, the closer that it is moving like a stock. The Delta of a call option will range from 0 to 100.
For example, if a stock has a 90 delta, it means that for every $1 the stock price rises, we can expect the options to increase $0.90 in value. Typically, at-the-money options have Delta’s of 45 to 57.
(ITM options can almost be like stock substitutes because their value is highly dependent on the stock price movements)
GAMMA: Merely is the delta of the delta. This is how much the delta will change based on the price movements of the underlying stock.
This is important near expiration because the delta of a call will either be 0 (worthless option) or 100 (in the money).
Theta: is the time element…this will tell us how much the option gains or losses daily as time passes.
Vega: this is the volatility element…this will tell us how much the option will gain/lose based on an increase or decrease in the options implied volatility.
Options Trading -Advanced Topics- Properties of Options
Properties of Call Options
Long Call: (+) delta, (+) vega, (-) theta
Short Call: (-) delta, (-) vega, (+) theta
Properties of Put Options
Long Put: (-) delta, (+) vega, (-) theta
Short Put: (+) delta, (-) vega, (+) theta
All things being equal, longer-dated options will more expensive than nearer term options.
All things being equal, the higher the implied volatility is, the more expensive options are.
Now, based on your strategy you can isolate the role of delta, vega, and theta.
For example, you can put on a trade that is directional and reduce the role of vega and theta…like a call spread or a put spread.
Historical Volatility: This measures the amount of variability (randomness) around the mean (the highest point on the bell-curve)…traders associate volatility with a specific period.
For example, one may use daily, weekly or monthly volatility periods to get a better understanding of how a stock has behaved in the past.
Volatility occurs when stocks go up or down…However, as the old saying goes on Wall Street “stocks take the escalator up and the elevator down”
In other words, for most stocks, volatility is at its highest when stocks are declining.
Implied Volatility: The market’s best guess on future volatility, based on the supply, demand, and order flow.
As mentioned previously, the price of an option is only worth what someone is willing to pay for it.
It is generally accepted that volatility is mean reverting.
Periods of high volatility are followed by low volatility ….and periods of low volatility are followed by high volatility.
Options Trading- Advanced Topics – Implied Volatility Skew
Option theory believes that returns are normally distributed. Of course, options theory is flawed. The market experiences kurtosis and skewness.
The above image shows the daily returns of a random stock for over one year. The chart also has a normal distribution overlayed.
You notice that there are more extreme moves than what the normal distribution expects, see the outliers in the corner (or tail). This is what is known as positive kurtosis.
Also, notice that most of the returns are occurring on the left-hand side; this is referred to as a negative skew.
Different Shapes of Implied Volatility
The left-hand side represents puts, and the right-hand side represents calls. The number 1 represents the ATM strike.
Typically, if you’re trading stock an en ETF like the SPDR S&P 500 (SPY), the equidistant OTM puts have higher implied volatility than the equidistant OTM call options.
This type of skew structure is referred to as a negative skew. Implied volatility tends to rise when equity prices drop.
During a market sell-off, portfolio managers may buy OTM puts for protection. In addition, they may even sell OTM call options to finance those puts, acting as a collar.
What should you be taking away from this?
Implied volatility is dynamic. It’s not the same for each strike price or contract period.
For example, speculators can sometimes juice up the premiums in OTM options, creating an opportunity for option sellers.
You can make a lot of money by merely trading puts and calls. However, if you strengthen your options knowledge, it opens doors to trade even more strategies. That said, if you’d like to learn more about options, check out this free eBook, written by a self-made multimillionaire, Jeff Bishop.