We are entering a new era of stock trading, which is option trading. Led by all the hype surrounding Robinhood and Reddit’s WallStreetBets forum, options trading has become very popular.
What are options?
Options are typically used as leveraged financial instruments. Each option contract is worth the value of 100 shares of stock. Options are generally used by big institutions to hedge extremely large positions of shares. However, options trading is slowly becoming a staple in the retail market, or general public of traders. Although options are a risky asset, there are various strategies, called spreads, that allow you to limit your risk when entering a position. We won’t get into all the strategies in this post because an in-depth article could be written about each. Use google to find different options strategies and how to implement them.
Lets start with the basics of option trading
There are two types option contracts that can be traded, calls and puts. In short, purchasing CALL options is a bullish play and purchasing PUT options are a bearish play. The reverse is also possible, you can sell CALL contracts on a stock and also sell PUT options. Each option type gives you the RIGHT to purchase shares of the underlying stock at a certain price at expiration. Here’s an example: You buy a CALL option on Starbucks for $1 with an expiration strike price of $100. At the expiration date of your contract, Starbucks is trading at $115. The contract has now given you the right to execute, or assign, 100 shares per contract to your account at the price of $100. The difference in stock price is $15 (the difference between the closing stock price and your strike price), your total profit is $14 per share for 100 shares. Don’t forget the $1 in premium you paid for those contracts. The one contract has netted you $140 per share whereas your maximum risk was only the one dollar price you paid per contract. If Starbucks mysteriously went bankrupt, you still would only lose the $1 per contract.
More Advanced Options Trading
Options prices are decided by two types of values: intrinsic and extrinsic value. Intrinsic value is the option contract’s strike price relative to the underlying’s stock price. A contract is IN THE MONEY if it holds intrinsic value, and OUT THE MONEY if it doesn’t. The extrinsic value of an option is decided by the greeks. As we get more knowledge of option trading you will need to learn about the Greek’s and how they affect an option’s price. Generally, an option is priced at what will most likely happen to the stock price by expiration. The variables, or the Greeks, that are used to calculate an option’s price are the following DELTA, GAMMA, THETA, VEGA, RHO. I’ll give you a brief description of the 4 popular greeks that you should have some understanding of before entering any options trades.
DELTA: Delta is the amount an option price is expected to move based on a one dollar change in the underlying stock price. As a general rule, DELTA will be greater when an option contract is in the money, and DELTA will be less when it is out of the money.
GAMMA: GAMMA is the rate that DELTA will change based on a $1 change in the stock price. GAMMA can be thought of as the “acceleration”, or the speed at which the option price changes. Options with higher GAMMA are more sensitive to changes in the price of the underlying stock.
THETA: THETA is known as the time-decay of an option contract and is usually an option sellers best friend. THETA is the amount of value an option contract will lose for every one-day change in time to expiration. Think about it, as your expiration date nears, if the underlying stock hasn’t moved in your favor, you will be losing time-value of that option.
VEGA: VEGA is the greek that responds to volatility. As volatility increases, the option price will also be effected, and typically will also increase with volatility. Why is this? Because in uncertain times with higher volatility, such as during market crashes or before earnings reports, there is a higher unknown of where the underlying might end up.
There are many things to learn about options trading. We won’t get into all the details on this post, but in summary here are a few key points to take away from this:
- Options can be traded the same way shares are traded, which means they change value as the stock moves in either direction. Many people believe once you purchase an option contract you need to hold it until expiration, which is untrue. It can be traded at any point in time, until it expires.
- Option contracts are high-risk high-reward leveraged financial instruments. This means that purchasing $10,000 in options vs $10,000 in shares is A LOT more of a risky investment. The potential for loss is much greater, but so is the potential profit. It is possible that a $10,000 position in options becomes worth $100,000, but it is also possible it becomes worthless. On the other side, it is very unlikely a $10,000 position in shares becomes $100,000 but also unlikely shares will drop to zero.
- The value of an option has two components, intrinsic and extrinsic value. Intrinsic value is determine by the in-the-money-ness of the option relative to the underlying. Extrinsic value is determined by the greeks, such as time and volatility.
- Although options are leveraged and higher risk, there are many strategies that can limit risk and also limit your downside. Do your due diligence on these strategies before entering any trades.