High effective options trading pattern called «Guide»

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Options Trading Strategies: A Guide for Beginners

Options are conditional derivative contracts that allow buyers of the contracts (option holders) to buy or sell a security at a chosen price. Option buyers are charged an amount called a “premium” by the sellers for such a right. Should market prices be unfavorable for option holders, they will let the option expire worthless, thus ensuring the losses are not higher than the premium. In contrast, option sellers (option writers) assume greater risk than the option buyers, which is why they demand this premium.

Options are divided into “call” and “put” options. With a call option, the buyer of the contract purchases the right to buy the underlying asset in the future at a predetermined price, called exercise price or strike price. With a put option, the buyer acquires the right to sell the underlying asset in the future at the predetermined price.

Why Trade Options Rather Than a Direct Asset?

There are some advantages to trading options. The Chicago Board of Options Exchange (CBOE) is the largest such exchange in the world, offering options on a wide variety of single stocks, ETFs and indexes. Traders can construct option strategies ranging from buying or selling a single option to very complex ones that involve multiple simultaneous option positions.

The following are basic option strategies for beginners.

Buying Calls (Long Call)

This is the preferred strategy for traders who:

  • Are “bullish” or confident on a particular stock, ETF or index and want to limit risk
  • Want to utilize leverage to take advantage of rising prices

Options are leveraged instruments, i.e., they allow traders to amplify the benefit by risking smaller amounts than would otherwise be required if trading the underlying asset itself. A standard option contract on a stock controls 100 shares of the underlying security.

Suppose a trader wants to invest $5,000 in Apple (AAPL), trading around $165 per share. With this amount, he or she can purchase 30 shares for $4,950. Suppose then that the price of the stock increases by 10% to $181.50 over the next month. Ignoring any brokerage, commission or transaction fees, the trader’s portfolio will rise to $5,445, leaving the trader with a net dollar return of $495, or 10% on the capital invested.

Now, let’s say a call option on the stock with a strike price of $165 that expires about a month from now costs $5.50 per share or $550 per contract. Given the trader’s available investment budget, he or she can buy nine options for a cost of $4,950. Because the option contract controls 100 shares, the trader is effectively making a deal on 900 shares. If the stock price increases 10% to $181.50 at expiration, the option will expire in the money and be worth $16.50 per share ($181.50-$165 strike), or $14,850 on 900 shares. That’s a net dollar return of $9,990, or 200% on the capital invested, a much larger return compared to trading the underlying asset directly. (For related reading, see “Should an Investor Hold or Exercise an Option?”)

Risk/Reward: The trader’s potential loss from a long call is limited to the premium paid. Potential profit is unlimited, as the option payoff will increase along with the underlying asset price until expiration, and there is theoretically no limit to how high it can go.

10 Options Strategies To Know

Traders often jump into trading options with little understanding of options strategies. There are many strategies available that limit risk and maximize return. With a little effort, traders can learn how to take advantage of the flexibility and power options offer. With this in mind, we’ve put together this primer, which should shorten the learning curve and point you in the right direction.

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4 Options Strategies To Know

1. Covered Call

With calls, one strategy is simply to buy a naked call option. You can also structure a basic covered call or buy-write. This is a very popular strategy because it generates income and reduces some risk of being long stock alone. The trade-off is that you must be willing to sell your shares at a set price: the short strike price. To execute the strategy, you purchase the underlying stock as you normally would, and simultaneously write (or sell) a call option on those same shares.

In this example we are using a call option on a stock, which represents 100 shares of stock per call option. For every 100 shares of stock you buy, you simultaneously sell 1 call option against it. It is referred to as a covered call because in the event that a stock rockets higher in price, your short call is covered by the long stock position. Investors might use this strategy when they have a short-term position in the stock and a neutral opinion on its direction. They might be looking to generate income (through the sale of the call premium), or protect against a potential decline in the underlying stock’s value.

In the P&L graph above, notice how as the stock price increases, the negative P&L from the call is offset by the long shares position. Because you receive premium from selling the call, as the stock moves through the strike price to the upside, the premium you received allows you to effectively sell your stock at a higher level than the strike price (strike + premium received). The covered call’s P&L graph looks a lot like a short naked put’s P&L graph.

Covered Call

2. Married Put

In a married put strategy, an investor purchases an asset (in this example, shares of stock), and simultaneously purchases put options for an equivalent number of shares. The holder of a put option has the right to sell stock at the strike price. Each contract is worth 100 shares. The reason an investor would use this strategy is simply to protect their downside risk when holding a stock. This strategy functions just like an insurance policy, and establishes a price floor should the stock’s price fall sharply.

An example of a married put would be if an investor buys 100 shares of stock and buys one put option simultaneously. This strategy is appealing because an investor is protected to the downside should a negative event occur. At the same time, the investor would participate in all of the upside if the stock gains in value. The only downside to this strategy occurs if the stock does not fall, in which case the investor loses the premium paid for the put option.

In the P&L graph above, the dashed line is the long stock position. With the long put and long stock positions combined, you can see that as the stock price falls the losses are limited. Yet, the stock participates in upside above the premium spent on the put. The married put’s P&L graph looks similar to a long call’s P&L graph.

What’s a Married Put?

3. Bull Call Spread

In a bull call spread strategy, an investor will simultaneously buy calls at a specific strike price and sell the same number of calls at a higher strike price. Both call options will have the same expiration and underlying asset. This type of vertical spread strategy is often used when an investor is bullish on the underlying and expects a moderate rise in the price of the asset. The investor limits his/her upside on the trade, but reduces the net premium spent compared to buying a naked call option outright.

In the P&L graph above, you can see that this is a bullish strategy, so the trader needs the stock to increase in price in order to make a profit on the trade. The trade-off when putting on a bull call spread is that your upside is limited, while your premium spent is reduced. If outright calls are expensive, one way to offset the higher premium is by selling higher strike calls against them. This is how a bull call spread is constructed.

How To Manage A Bull Call Spread

4. Bear Put Spread

The bear put spread strategy is another form of vertical spread. In this strategy, the investor will simultaneously purchase put options at a specific strike price and sell the same number of puts at a lower strike price. Both options would be for the same underlying asset and have the same expiration date. This strategy is used when the trader is bearish and expects the underlying asset’s price to decline. It offers both limited losses and limited gains.

In the P&L graph above, you can see that this is a bearish strategy, so you need the stock to fall in order to profit. The trade-off when employing a bear put spread is that your upside is limited, but your premium spent is reduced. If outright puts are expensive, one way to offset the high premium is by selling lower strike puts against them. This is how a bear put spread is constructed.

5. Protective Collar

A protective collar strategy is performed by purchasing an out-of-the-money put option and simultaneously writing an out-of-the-money call option for the same underlying asset and expiration. This strategy is often used by investors after a long position in a stock has experienced substantial gains. This options combination allows investors to have downside protection (long puts to lock in profits), while having the trade-off of potentially being obligated to sell shares at a higher price (selling higher = more profit than at current stock levels).

A simple example would be if an investor is long 100 shares of IBM at $50 and IBM has risen to $100 as of January 1 st . The investor could construct a protective collar by selling one IBM March 15 th 105 call and simultaneously buying one IBM March 95 put. The trader is protected below $95 until March 15 th , with the trade-off of potentially having the obligation to sell his/her shares at $105.

In the P&L graph above, you can see that the protective collar is a mix of a covered call and a long put. This is a neutral trade set-up, meaning that you are protected in the event of falling stock, but with the trade-off of having the potential obligation to sell your long stock at the short call strike. Again, though, the investor should be happy to do so, as they have already experienced gains in the underlying shares.

What is a Protective Collar?

6. Long Straddle

A long straddle options strategy is when an investor simultaneously purchases a call and put option on the same underlying asset, with the same strike price and expiration date. An investor will often use this strategy when he or she believes the price of the underlying asset will move significantly out of a range, but is unsure of which direction the move will take. This strategy allows the investor to have the opportunity for theoretically unlimited gains, while the maximum loss is limited only to the cost of both options contracts combined.

In the P&L graph above, notice how there are two breakeven points. This strategy becomes profitable when the stock makes a large move in one direction or the other. The investor doesn’t care which direction the stock moves, only that it is a greater move than the total premium the investor paid for the structure.

What’s a Long Straddle?

7. Long Strangle

In a long strangle options strategy, the investor purchases an out-of-the-money call option and an out-of-the-money put option simultaneously on the same underlying asset and expiration date. An investor who uses this strategy believes the underlying asset’s price will experience a very large movement, but is unsure of which direction the move will take.

This could, for example, be a wager on an earnings release for a company or an FDA event for a health care stock. Losses are limited to the costs (or premium spent) for both options. Strangles will almost always be less expensive than straddles because the options purchased are out of the money.

In the P&L graph above, notice how there are two breakeven points. This strategy becomes profitable when the stock makes a very large move in one direction or the other. Again, the investor doesn’t care which direction the stock moves, only that it is a greater move than the total premium the investor paid for the structure.

Strangle

8. Long Call Butterfly Spread

All of the strategies up to this point have required a combination of two different positions or contracts. In a long butterfly spread using call options, an investor will combine both a bull spread strategy and a bear spread strategy, and use three different strike prices. All options are for the same underlying asset and expiration date.

For example, a long butterfly spread can be constructed by purchasing one in-the-money call option at a lower strike price, while selling two at-the-money call options, and buying one out-of-the-money call option. A balanced butterfly spread will have the same wing widths. This example is called a “call fly” and results in a net debit. An investor would enter into a long butterfly call spread when they think the stock will not move much by expiration.

In the P&L graph above, notice how the maximum gain is made when the stock remains unchanged up until expiration (right at the ATM strike). The further away the stock moves from the ATM strikes, the greater the negative change in P&L. Maximum loss occurs when the stock settles at the lower strike or below, or if the stock settles at or above the higher strike call. This strategy has both limited upside and limited downside.

9. Iron Condor

An even more interesting strategy is the iron condor. In this strategy, the investor simultaneously holds a bull put spread and a bear call spread. The iron condor is constructed by selling one out-of-the-money put and buying one out-of-the-money put of a lower strike (bull put spread), and selling one out-of-the-money call and buying one out-of-the-money call of a higher strike (bear call spread). All options have the same expiration date and are on the same underlying asset. Typically, the put and call sides have the same spread width. This trading strategy earns a net premium on the structure and is designed to take advantage of a stock experiencing low volatility. Many traders like this trade for its perceived high probability of earning a small amount of premium.

In the P&L graph above, notice how the maximum gain is made when the stock remains in a relatively wide trading range, which would result in the investor earning the total net credit received when constructing the trade. The further away the stock moves through the short strikes (lower for the put, higher for the call), the greater the loss up to the maximum loss. Maximum loss is usually significantly higher than the maximum gain, which intuitively makes sense given that there is a higher probability of the structure finishing with a small gain.

10. Iron Butterfly

The final options strategy we will demonstrate is the iron butterfly. In this strategy, an investor will sell an at-the-money put and buy an out-of-the-money put, while also selling an at-the-money call and buying an out-of-the-money call. All options have the same expiration date and are on the same underlying asset. Although similar to a butterfly spread, this strategy differs because it uses both calls and puts, as opposed to one or the other.

This strategy essentially combines selling an at-the-money straddle and buying protective “wings.” You can also think of the construction as two spreads. It is common to have the same width for both spreads. The long out-of-the-money call protects against unlimited downside. The long out-of-the-money put protects against downside from the short put strike to zero. Profit and loss are both limited within a specific range, depending on the strike prices of the options used. Investors like this strategy for the income it generates and the higher probability of a small gain with a non-volatile stock.

In the P&L graph above, notice how the maximum gain is made when the stock remains at the at-the-money strikes of the call and put sold. The maximum gain is the total net premium received. Maximum loss occurs when the stock moves above the long call strike or below the long put strike. (For related reading, see “Best Online Stock Brokers for Options Trading 2020”)

Options Trading Beginners Guide for 2020

Posted by Mark Wolfinger | Last updated on Jan 7th, 2020 | Published May 11th, 2009

Why trade options? If you have the skill (or luck) to know when a stock is going to move higher or lower, why not just buy or short the shares? The same can be said for commodities – why trade options when you can trade futures contracts?

Too many people look at options as tools for speculation. Sure, options provide leverage, giving you the possibility of turning a few hundred dollars into several thousand dollars. And yes, that possibility is attractive. But do you play the lottery – just because the prize is huge? Everyone knows the lottery is a bad bet and that the chances of winning are terrible.

But options cost more than lottery tickets and the payoff is smaller. The probability of success is small because so much must go your way when you buy options: price change, timing of that change, size of the change. It’s a tough road.

Options were not designed as tools for speculation, and if you want to get the most out of options, consider using them as they were designed – as risk-reducing investment tools.

Options, when used properly, allow an investor to reduce risk and provide an improved chance to profit from stock market investments.

First, it’s necessary to understand the basic principles behind options trading. It is important to understand how options work before you consider trading them. Let’s dive in.

Options Trading Beginner Points

Here’s what new investors need to know about options:

  1. An option is an agreement, or contract, between two parties: a buyer and a seller.
  2. Exchange traded option contracts are guaranteed by the Options Clearing Corporation (OCC). There has never been a default in the 40+ year history of the OCC.
  3. There are two types of options: calls and puts.
  4. The option buyer pays a premium to the seller.
  5. In return for receiving the premium, the seller grants specific rights to the buyer and accepts specific obligations.
  6. A call option grants its owner the right to buy a specific item (contract) at a specified price (called the strike price) for a limited time.
  7. A put option grants its owner the right to sell a specific item (contract) at the strike price for a limited time.
  8. Each contract represents 100 shares of stock. The generic name is the, “underlying asset.”
  9. The limited time ends on the option expiration date. Equity options expire on the third Friday of the month, after the market closes for trading (technically expiration is the following morning, but the last time you may sell or exercise an option is the third Friday).
  10. An option seller may become obligated to honor the conditions of the contract – i.e., sell stock to the call owner or buy stock from the put owner. If the option expires worthless, then the option seller is relieved of his/her obligations.

As the owner of the option, you can either A. sell it on the open market like you would shares, B. you can exercise it, or C. Allow it to become worthless (if expiration day arrives and the option has neither been sold, nor exercised, it expires worthless).

Exercising is the process by which an option owner does what the contract allows. Thus, a call owner can exercise the option, and buy 100 shares of the specified stock at the strike price per share – as long as the option has not yet expired. A put owner may sell 100 shares at the strike price. In practice, it’s more efficient to sell an option, rather than exercise.

Options Versus Stocks Differences

While obvious, it is important to emphasize: options are not stocks. With stocks, you are holding shares or ownership in a company. Contrarily, options are time restricted contracts that represent shares (100 shares per contract).

Option prices depend on far more than supply and demand. When markets are generally calm, option prices tend to decrease. When markets are volatile, option prices tend to increase. And that’s true for puts and calls.

Here are the three most important differences between stocks and options:

  1. Options expire while stock shares last forever (unless the company goes bankrupt or gets acquired).
  2. Options are derivative products. Their value is derived from the value of another asset. Stocks are assets, and have an intrinsic value based on the company they represent.
  3. Option owners have rights, but do not own anything tangible. Stock owners are entitled to dividends and own a voting share of the company.

Reasons to Trade Options

If you are a typical stock market investor, you adopted a buy and hold philosophy and own stocks, ETFs, or mutual funds. If you are a hands-on investor, you likely do research and carefully select stocks to buy. It’s difficult to beat the market, and most professional money managers underperform.

Investors tend to be long. They own stocks. They don’t know how to hedge, or reduce the risk of owning, investments. That’s why options are so important. To me, it’s unfortunate that so few brokers help clients to adopt risk-reducing strategies with options.

Here are seven great reasons why you should take time to learn how options work:

  1. Hedging – Options allow you to reduce the risk of investing in the stock market. Imagine how investors everywhere would feel if they learned that the giant losses they suffered were unnecessary. By using appropriate hedging strategies, losses can be reduced significantly.
  2. Insurance – You can buy insurance that protects the value of your portfolio – just as you buy insurance to protect the value of your home or car. Using options, there are strategies that allow you to own insurance for little, or no, cost.
  3. Income – By selling someone else the right to buy your stock at a predetermined price (selling a call option), you are paid a premium that you can consider to be a special dividend.
  4. Leverage – With options, you have the ability to avoid trading shares of stock altogether. Options also allow you to take a position with far less capital invested than buying shares outright.
  5. No Need to Always Be Bullish – Options allow you to create positions that prosper when the market moves higher, lower, or trades in a range. Traditional long investors only profit when stocks move higher.
  6. Limited risk – You can adopt strategies with limited loss, but with high probability of success. The trade off is that profits are also limited. The limited loss nature of so many option strategies is one important factor that makes them so attractive.
  7. Indexing – If you prefer to trade a diversified portfolio rather than individual stocks, the major indexes (e.g., S&P 500, DJIA, Russell 2000, etc) have options you can trade.

Basic Types of Options Trades

Beginner options traders often get stuck when entering an order because they have not yet learned which of the four choices applies.

When you trade options, there are four ways in which each trade can be described:

Buy to Open

A. An order to buy a specific option
B. You are initiating a new position, or increasing an existing position

Buy to Close

A. An order to buy a specific option
B. You are buying an option that you previously sold
C. You are reducing or exiting (closing) an existing position

Sell to Open

A. An order to sell a specific option
B. You are writing (selling) an option you do not own
C. You are initiating a new position, or increasing an existing position

Sell to Close

A. An order to sell a specific option
B. You are selling an option you bought earlier
C. You are reducing or exiting an existing position

Note: When you trade options spreads (multiple options contracts in combination), you are entering an order to trade at least two different options simultaneously. When you initiate the trade, the appropriate boxes to check are: ‘Buy to open’ for the option you buy and ‘sell to open’ for the option you sell.

Some online brokers require that you specify into which of the four categories your trade falls. Others don’t ask because it’s a simple matter for their computers to gather the information.

Option rookies are often eager to begin trading – too eager. It’s important to get a solid foundation to be certain you understand how options work and how they can help you achieve your goals – before trading.

Here’s a list of my favorite methods. Note: this list contains strategies that are easy to learn and understand. Each is less risky than owning stock. Most involve limited risk. For investors not familiar with options lingo read our beginners options terms and intermediate options terms posts.

1. Writing covered calls

Using stock you already own (or buy new shares), you sell someone else a call option that grants the buyer the right to buy your stock at a specified price. That limits profit potential. You collect a cash premium that is yours to keep, no matter what else happens. That cash reduces your cost. Thus, if the stock declines in price, you may incur a loss, but you are better off than if you simply owned the shares.

Example: Buy 100 shares of IBM
Sell one IBM Jan 110 call

2. Writing cash-secured naked puts

Sell a put option on a stock you want to own, choosing a strike price that represents the price you are willing to pay for stock. You collect a cash premium in return for accepting an obligation to buy stock by paying the strike price. You may not buy the stock, but if you don’t, you keep the premium as a consolation prize. If you maintain enough cash in your brokerage account to buy the shares (if the put owner exercises the put), then you are considered to be ‘cash-secured.’

Example: Sell one AMZN Jul 50 put; maintain $5,000 in account

3. Collars

A collar is a covered call position, with the addition of a put. The put acts as an insurance policy and limit losses to a minimal (but adjustable) amount. Profits are also limited, but conservative investors find that it’s a good trade-off to limit profits in return for limited losses.

Example: Buy 100 shares of IBM
Sell one IBM Jan 110 call
Buy one IBM Jan 95 put

4. Credit spreads

The purchase of one call option, and the sale of another. Or the purchase of one put option, and the sale of another. Both options have the same expiration. It’s called a credit spread because the investor collects cash for the trade. Thus, the higher priced option is sold, and a less expensive, further out of the money option is bought. This strategy has a market bias (call spread is bearish and put spread is bullish) with limited profits and limited losses.

Example: Buy 5 JNJ Jul 60 calls
Sell 5 JNJ Jul 55 calls

or Buy 5 SPY Apr 78 puts
Sell 5 SPY Apr 80 puts

5. Iron condors

A position that consists of one call credit spread and one put credit spread. Again, gains and losses are limited.

Example: Buy 2 SPX May 880 calls
Sell 2 SPX May 860 calls

and Buy 2 SPX May 740 puts
Sell 2 SPX May 760 puts

6. Diagonal (or double diagonal) spreads

These are spreads in which the options have different strike prices and different expiration dates.

1. The option bought expires later than the option sold
2. The option bought is further out of the money than the option sold

Example: Buy 7 XOM Nov 80 calls
Sell 7 XOM Oct 75 calls This is a diagonal spread

Or Buy 7 XOM Nov 60 puts
Sell 7 XOM Oct 65 puts This is a diagonal spread

If you own both positions at the same time, it’s a double diagonal spread

What about buying naked calls or puts?

Note that buying calls or puts is NOT on this list, despite the fact that the majority of rookies begin their option trading careers by adopting that strategy. True, it’s fun to buy an option and treat it as a mini-lottery ticket. But, that’s gambling. The likelihood of consistently making money when buying naked options is very small, and it’s not a strategy I endorse.

How to Value Options

While stock prices depend primarily on supply and demand (buyers versus sellers), option prices depend on many factors, each of which affects the price of an option in the marketplace. Here are some of the most important factors:

1. Price of the underlying

If you own a call option, you have the right to buy stock at a specific price (strike price). For example, if you own one Nov 40 call, you can buy 100 shares at $40 per share. Wouldn’t you pay more to own that call if the stock is $39 than if it’s $35? Would you pay even more if the stock price is $43? I hope you replied ‘yes.’ That’s why calls are worth more as the stock rises.

2. Option type

A call gives you the right to buy shares and a put gives you the right to sell shares. Thus you cannot expect put and call prices to move in tandem. When the stock moves higher, call options increase in value and put options decrease in value.

3. Time to Expiration

When you own an option, you want to see the stock move higher (call option) or lower (put option). The more time that remains before an option expires, the greater the chance that a favorable more will occur. Thus, more time makes all options more valuable. It’s true that more time allows the stock to make an unfavorable move, but that’s not the significant factor in determining a price of an option. It’s the potential payoff, and the probability of receiving that payoff, that determines an option’s value.

4. Interest Rates

Call options can be used as an alternative to owning stock. When you buy stock, you must use cash, and that cash could be invested to earn interest. Thus, the more interest you earn on your cash, the more you should be willing to pay for a call option. This is not a significant factor in determining an option’s value.

5. Strike Price

When you buy stock, you want to pay the lowest possible price. Thus, the right to buy stock at $25 per share is more valuable than the right to buy stock at $30 per share. For that reason, call options increase in value as the strike price decreases.

When selling stock, you want to receive the highest possible price. Thus, it’s more valuable to own the right to sell shares at $60 than the right to sell shares at $55. Puts are worth more as the strike price increases.

6. Dividend

When a stock pays a dividend, its price declines by the amount of that dividend. That occurs when the stock ‘goes ex-dividend’ (the buyer is not entitled to receive the dividend). The higher the dividend, the more the price declines. Because a lower stock price is not good for the call owner, as the dividend increases, the value of a call option decreases. Similarly, the value of a put option increases.

These options do not suddenly change price when the stock goes ex-dividend. The model (modified Black-Scholes) that determines the fair value of an option ‘knows’ that the stock has a dividend in its future, and the effect of that dividend is already priced into the option when you buy or sell it.

7. Volatility

This is the crucial factor in determining the price of an option. Each of the other factors involved in an option’s price is known with certainty. But the volatility estimate used to calculate the value of an option refers to the future volatility. Specifically: how volatile is the stock going to be between the time the option is purchased and the time it expires? Because the future is unknown, the volatility component of an option’s price can only be estimated. Different people make different estimates, and thus, each has a different idea as to the value of an option. If you notice options changing price when the stock doesn’t move (or vice versa) it’s likely due to a change in the volatility estimate.

To provide even more clarity here, when you own an option, you want the stock price to change by a large amount because when the stock moves far beyond the strike, the value of your option increases. When stocks are not very volatile and undergo daily price changes of just a few pennies, a big move is unlikely. But when the stock price frequently changes by 5% in a single day, a few of those moves in the same direction can provide a handsome profit. Thus, the options of more volatile stocks are worth a great deal more than options of non-volatile stocks.

Options Greeks

When dealing with options, it’s possible to measure and modify the risk of any stock market investment. You can take steps you deem necessary to offset as little, or as much, of that risk as desired. When calculating various risks, a set of Greek letters, collectively known as ‘the Greeks,’ are used to measure (or quantify) specific risks associated with an investment.

Let’s take a quick look at a few of the more important, and commonly used, Greeks: delta, gamma, theta, and vega. NOTE: Vega is not a Greek letter, but apparently that’s not an issue.

  • Delta measures the rate at which the price of an option changes when the underlying asset (stock, ETF or index) moves one point. Delta is not constant.
  • Gamma measure the rate at which delta changes as the underlying moves one point.
  • Theta measures the amount by which the value of an option decreases as one day passes. Thus, theta is ‘time decay.’
  • Vega measures the sensitivity of the option’s price to a change in the implied volatility (IV), and represents the amount by which the option value changes when IV moves higher or lower by one point.

By calculating the delta, gamma, theta and vega of a position, specific risk parameters are measured, and thus, can be adjusted to suit the risk tolerance of the investor. And don’t worry, every online broker will calculate the Greeks for you.

How to Read an Option Chain

It’s good to understand specific option strategies and the reasons for adopting them, but for true rookies, something else is needed – and that’s an understanding of how to read an option chain to place a trade. Each broker has its individual trading platform, but if you learn to use one platform, the general principles should transfer to another.

Let’s look at a typical option chain from the Chicago Board Options Exchange (CBOE). Below is information for some IBM options.

1. Calls. This is a (partial) list of call options that are listed for trading at the various options exchanges. The next six columns refer to specific call options.

  • The first row contains: “09 Apr 90.00 IBM (IBM DR – E)”
  • “09” refers to the year in which the option expires, or 2009
  • “Apr” is the expiration month. For all options on individual stocks, expiration day is Saturday, one day after the 3rd Friday
  • “90.00” is the strike price, or the price at which the owner of this call option has the right to buy 100 shares of IBM. It is customary to ignore the decimals when they are ‘00’
  • “IBM” is the ticker symbol for the underlying stock
  • “IBM DR” is the symbol that describes the specific option. “D” represents the expiration month (April). “R” represents the strike price (90). The last letter is not part of the symbol. It’s used to designate the exchange from which market data is taken, and “E” stands for CBOE

2. Last sale. The most recent price at which the option traded. This number is seldom useful because you cannot tell whether the last trade occurred 5 seconds or 5 hours ago.

3. Net. This column shows today’s price change. It’s the difference between the last price and yesterday’s last price. This column serves no practical purpose. Red numbers indicate today’s price is lower, and green means higher.

4. Bid. The highest advertised price anyone is willing to pay for this option at this time. Be aware that the ‘real’ bid is often not published and that there’s a reasonable chance you can sell the option at a higher price.

5. Ask. The lowest advertised price that anyone is willing to accept when selling this option at this time. Be aware that the ‘real’ ask price is often not published and that there’s a chance you can buy the option at a lower price. When the bid/ask spread is wide, the chances of obtaining a better price (when you enter an order) are excellent.

6. Vol. (Volume) The number of option contracts that traded today on this exchange. If no exchange is specified, then it’s the total volume on all exchanges.

7. Open Int. (Open Interest) The total number of this specific option that exists. In other words, the open interest equals the number of options written (sold) that have not yet been bought back or exercised. This number is not ‘live’ and is published once per day, prior to the opening. Notice that the open interest tends to be highest for options whose strike price is nearest the stock price.

8. Puts. The same data is repeated for the put options.

  • Note: The option symbol has one major difference: The letter used to represent the expiration month is not the same as the letter used to represent the call expiration month. That’s convenient because you can determine whether an option is a call or put by its symbol. The letters A to L represent Jan thru December for calls. The letters M to X represent Jan thru Dec for puts. Thus, the first row contains the IBM Apr 90 put, symbol IBM PR. Where P = April expiration for puts
  • The letter representing the strike price is the same for calls and puts. IBM PR is the IBM put, expiring in Apr, strike price 90.

Your First Options Trade: Writing a Covered Call

If you are an investor who has experience buying and selling stocks, then it should be easy for you to make the transition to writing covered calls. Why? Because this option strategy begins with the purchase of stock – and you are already familiar with that process and the decisions required.

Writing covered calls is neither the best nor safest strategy available, but it’s safer than owning stocks outright and it gives you experience using options. Writing a basic covered call is my recommended first option trades.

Here are three reasons why writing covered calls makes sense as an introduction to the world of options:

Covered calls are an easy to understand strategy.

  1. You sell someone else the right to buy your stock at a specified price (strike price)
  2. You collect cash for making that sale
  3. The agreement has a limited lifetime
  4. If the other person declines to buy your stock by the deadline, the agreement expires and you are no longer obligated to sell your shares.

Covered Calls can lead to many more profitable trades when compared with buying stock.

  1. If the stock declines, you lose less than the person who did not write a covered call.
  2. If the stock declines by less than the premium you collected, you earn a profit.
  3. If the stock is relatively unchanged when expiration day arrives, you have a profit while the buy and hold investor breaks even.
  4. If the stock moves beyond the strike price by less than the premium collected, you earn more than the buy and hold investor.
  5. If the stock undergoes a significant price increase, that’s the only scenario in which you earn less than the buy and hold investor

Bottom line, covered calls provide options traders more frequent profits and overall reduce risk. By collecting cash for selling the call, you are effectively reducing your cost basis for the shares of stock you own. Thus, covered calls do not remove risk altogether, but they do reduce risk from holding shares long without any protection.

9 Easy Tips for Option Trading Success

Most investors who are looking for ‘tips’ for option trading success have the wrong perspective. They seek tricks, special strategies, or ‘can’t-miss’ gimmicks. There are no such things.

Options are the best investment vehicles around. They allow investors to take long, short, or neutral positions. They allow you to manage risk far better than any other investment method. Use them wisely and they will treat you well.

Here are nine easy tips for new options traders to follow if they want to be successful:

1. Options are best used as risk-reducing investment tools, not instruments for gambling.

2. Use the options Greeks to measure risk.

3. Manage risk carefully. Do not hold any position than can – in the worst case scenario – cost more than you are willing to lose.

4. Be careful about the number of option contracts you trade. It’s easy to over-trade with inexpensive option contracts – especially when selling.

5. Don’t go broke. Never allow an unexpected event to wipe out your account.

6. Do not expect miracles. Do not buy options that are far out of the money just because they are ‘cheap.’ The chances of success are tiny. Not zero, just tiny.

7. Selling naked options is less risky than buying stock. But, like stock ownership, there is considerable downside risk. Exception: It’s reasonable to sell naked puts – but only if you want to buy the shares, if assigned an exercise notice.

8. Limit losses. The most effective way to accomplish that is to buy one option for every option you sell. That means selling spreads, rather than naked options.

9. Hope is not a strategy. When a position goes bad, consider reducing risk. Doing nothing and hoping for a good outcome is nothing more than gambling.

Additional Options Resources

To wrap this guide up, here is a list of excellent articles across the web to help you learn options trading and trade successfully:

Mark Wolfinger, @MarkWolfinger, is a 20 year CBOE options veteran and is the author of the book, The Rookie’s Guide to Options.

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