Options 101

1. Options basics: Contracts, not assets

"Options are simply trading vehicles. The level of risk is correlated to your position size and the odds of success in your time frame before contract expiration."

Defining options. Options are contracts that give the buyer the right, but not the obligation, to buy (call) or sell (put) an underlying asset at a specific price (strike price) by a certain date (expiration). Unlike stocks, options are not ownership in a company but a bet on future price movement.

Risk and reward. The key advantage of options is their leverage: controlling a large number of shares with a small amount of capital. This allows for potentially higher returns, but also comes with increased risk. The maximum loss for buying options is limited to the premium paid, while the potential profit is theoretically unlimited for calls and limited to the strike price for puts.

Liquidity considerations.

• Only trade options with high volume and tight bid-ask spreads
• Popular stocks and ETFs like Apple, Google, SPY, and QQQ tend to have the most liquid options
• Avoid options with bid-ask spreads wider than 10% of the option's price

2. Leverage and risk management with options

"Options can fall to zero or go up 1000%, and you must have a plan for either possibility."

Position sizing is crucial. Never risk more than 1% of your total trading capital on a single option trade. This limits your worst-case scenario loss and allows your account to withstand multiple losing trades in a row.

Asymmetric risk-reward. Options provide an opportunity for asymmetric returns: limited downside (the premium paid) with potentially unlimited upside. This makes them powerful tools for both speculation and hedging.

Risk management strategies:

• Use stop losses based on key price levels of the underlying asset, not arbitrary option price declines
• Consider using spreads to limit risk when selling options
• For longer-term trades, use options with more time until expiration to reduce the impact of time decay

3. The Greeks: Essential metrics for option pricing

"Understanding the odds based on your option Delta can be very enlightening."

The four main Greeks:

• Delta: Measures the rate of change in option price for every $1 move in the underlying asset
• Theta: Represents time decay, or how much value an option loses each day
• Vega: Shows sensitivity to changes in implied volatility
• Gamma: Indicates the rate of change in Delta

Practical applications. Understanding the Greeks helps traders make more informed decisions:

• Use Delta to estimate the probability of an option expiring in-the-money
• Be aware of accelerating Theta decay in the final weeks before expiration
• Consider Vega when trading through high-volatility events like earnings

Gamma scalping. Advanced traders can use Gamma to profit from rapid changes in Delta, buying out-of-the-money options with low premiums and selling when the odds of profitability increase.

4. Common pitfalls in option trading

"New option traders buy far out of the money options without understanding how the odds are stacked against them."

Avoid lottery ticket mentality. Far out-of-the-money options are cheap for a reason – they have a very low probability of profiting. Even if the underlying asset moves in your favor, the option may not increase in value enough to overcome time decay.

Understand implied volatility. Options prices include expectations for future volatility, especially around events like earnings. After the event, this "volatility premium" disappears, potentially leading to losses even if you correctly predicted the direction of the price move.

Common mistakes to avoid:

• Overtrading or using excessive position sizes
• Ignoring liquidity and wide bid-ask spreads
• Not giving trades enough time to work (buying options too close to expiration)
• Failing to consider the impact of implied volatility changes

5. In-the-money vs. out-of-the-money options

"With in the money options, you take on the risk of intrinsic value and you only need be right about the direction."

In-the-money (ITM) options:

• Have intrinsic value (current price is favorable to the strike price)
• Move more closely with the underlying asset (higher Delta)
• Offer a higher probability of profit but require more capital

Out-of-the-money (OTM) options:

• Have no intrinsic value, only extrinsic (time) value
• Offer higher potential returns but lower probability of profit
• Are more sensitive to time decay and changes in implied volatility

Strategy considerations. ITM options are better for directional trades where you're confident in the trend but want to limit risk. OTM options are more suitable for speculating on large moves or as cheap hedges against existing positions.

6. Weekly options: High-risk, high-reward tools

"Weekly options have very high Deltas and most of them are very liquid. They are ideal for traders that are trading on a daily or weekly time frame with entries and exits in their preexisting stock trading system."

Advantages of weeklies:

• Provide access to large stock positions with minimal capital
• Allow for quick, high-leverage trades on short-term market moves
• Offer frequent opportunities due to weekly expirations

Risks and considerations:

• Extremely sensitive to time decay (Theta)
• Require precise timing and directional accuracy
• Can lead to rapid losses if not managed properly

Best practices for weekly options:

• Use them as stock replacements with in-the-money options
• Maintain strict position sizing (no more than 1% of account per trade)
• Have a clear exit strategy before entering the trade
• Consider selling premium with defined risk (e.g., credit spreads) rather than buying

7. Rolling options: Maximizing profits in trends

"Rolling option contracts up and forward is a tool for capturing trending markets."

The rolling process:

1. Buy an in-the-money option on a trending asset
2. As the option becomes deep in-the-money, sell it for a profit
3. Use the proceeds to buy a new at-the-money or slightly in-the-money option
4. Repeat as the trend continues

Benefits of rolling:

• Locks in profits from the initial trade
• Reduces capital at risk while maintaining exposure to the trend
• Allows for capturing larger moves over time without holding to expiration

Considerations:

• Only roll into options with good liquidity
• Be prepared to exit the entire position if the trend reverses
• Consider rolling on pullbacks to get better entry prices on new options

8. The dangers of covered calls

"In a bear market, you are taking on all the downside risk of your stock falling for the compensation of a small option contract premium."

Why covered calls can be risky:

• Cap upside potential in strong bull markets
• Provide minimal downside protection in bear markets
• Can lead to missed opportunities for significant gains

The asymmetric risk problem:

• You receive a small premium for selling the call
• But you retain all the downside risk of owning the stock
• In a sharp market decline, years of premium income can be wiped out

Alternative strategies to consider:

• Buying protective puts to hedge downside risk
• Using collars (selling calls and buying puts) for more balanced protection
• Focusing on directional option trades aligned with market trends

Last updated: July 29, 2024