How to Trade Stock Options – Your #1 Guide to Success

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Contents

10 Traits of a Successful Options Trader

Options are one of the most versatile instruments in the financial markets. Their flexibility allows the trader to leverage their position to boost returns. These products also allow the user to manage risk by using them for hedging or to make a profit from the upside, downside, and sideways movement in the market.

Despite its many benefits, options trading carries substantial risk of loss, and it is very speculative in nature. Not everyone can become a successful options trader. Like any other business, becoming a successful options trader requires a certain skill set, personality type, and attitude.

1. Be Able to Manage Risk

Options are high-risk instruments, and it is important for traders to recognize how much risk they have at any point in time. What is the maximum downside of the trade? What is the implicit or explicit position with respect to volatility? How much of my capital is allocated to the trade? These are some of the questions traders always have to keep in their minds.

Traders also need to take appropriate measures to control risk. In particular, if you are a short-term options trader, you will regularly come across loss-making trades. For example, if you hold a position overnight, your bet may go bad because of adverse news. You need to be able to minimize the risk of your positions at any time. Some traders do so by limiting their trade size and diversifying into many different trades so all their eggs aren’t in the same basket.

An options trader also has to be an excellent money manager. They need to use their capital wisely. For example, it wouldn’t be wise to block 90% of your capital in a single trade. Whatever strategy you adopt, risk management and money management cannot be ignored.

2. Be Good With Numbers

While trading in options, you are always dealing with numbers. What’s the implied volatility? Is the option in the money or out of the money? What’s the break-even of the trade? Options traders are always answering these questions. They also refer to option Greeks, such as the delta, gamma, vega, and theta of their options trades. For example, a trader would want to know if his trade is short gamma.

3. Have Discipline

To become successful, options traders must practice discipline. Doing extensive research, identifying opportunities, setting up the right trade, forming and sticking to a strategy, setting up goals, and forming an exit strategy are all part of the discipline. A simple example of deviating from the discipline is following the herd. Never trust an opinion without doing your own research. You can’t skip your homework and blame the herd for your losses. Instead, you must devise an independent trading strategy that works in order for it to be a successful options strategy.

While formal education in the form of higher degrees can be associated with elite traders, it is not necessarily the case for all. But you must be educated about the market. Successful traders take time to learn the basics and study the market—various scenarios, different trends—anything and everything about how the market works. They are not usually novices who have taken a three-hour trading seminar on “How to get rich quick trading,” but rather take the time to learn from the market.

4. Be Patient

Patience is one quality all options traders have. Patient investors are willing to wait for the market to provide the right opportunity, rather than trying to make a big win on every market movement. You will often see traders sitting idle and watching the market, waiting for the perfect time to enter or exit a trade. The same is not the case with amateur traders. They are impatient, unable to control their emotions, and they will be quick to enter and exit trades.

5. Develop a Trading Style

Each trader has a different personality and should adopt a trading style that suits his or her traits. Some traders may be good at day trading, where they buy and sell options several times during the day to make small profits. Some may be more comfortable with position trading, where they form trading strategies to take advantage of unique opportunities, such as time decay and volatility. And others may be more comfortable with swing trading, where traders make bets on price movement over periods lasting five to 30 days.

6. Interpret the News

It is crucial for traders to be able to interpret the news, separate hype from reality and make appropriate decisions based on this knowledge. You will find many traders eager to put their capital in an option with promising news, and the next day they will move on to the next big news. This distracts them from identifying bigger trends in the market. Most successful traders will be honest with themselves and make sound personal decisions, rather than just going by the top stories in the news.

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7. Be an Active Learner

The Chicago Board of Trade (CBOT) reported 90% of options traders will realize losses. What separates successful traders from average ones is successful traders are able to learn from their losses and implement what they learn in their trading strategies. Elite traders practice…and practice some more until they learn the lessons behind the trade, understand the economics behind the market and see the market behavior as it is happening.

The financial markets are constantly changing and evolving; you need to have a clear understanding of what’s happening and how it all works. By becoming an active learner, you will not only become good at your current trading strategies, but you will also be able to identify new opportunities others might not see or may pass over.

8. Be Flexible

You cannot stake a claim on the market but must go with the market or leave it when it is not the type that suits you. You must accept losses occur and that it is inevitable that you will lose. Acceptance rather than fighting the market is paramount to understanding, clarity and finally winning.

9. Plan Your Trades

An options trader who plans is more likely to succeed than one who operates on instinct and feel. If you don’t have a plan, you will place random trades, and consequently, you’ll be directionless. On the other hand, if you have a plan, you are more likely to stick to it. You will be clear about what your goals are and how you plan to achieve them. You will also know how to cover your losses or when to book profits. You can see how the plan has worked (or not worked) for you. All these steps are essential to developing a strong trading strategy.

10. Maintain Records

Most successful options traders keep diligent records of their trades. Maintaining proper trade records is an essential habit to help you avoid making costly decisions. The history of your trade records also provides a wealth of information to help you improve your odds of success.

The Bottom Line

Top options traders get a thrill from scouting and watching their trades. Sure, it’s great to see a pick come out on top, but much like sports fans, options traders enjoy watching the whole game unfold, not just finding out the final score. These characteristics will not guarantee your success in the options trading world, but they will definitely increase your chances at it.

11 (Core) Tips for Stock Options Trading Success + Video

Interested in Trading Stock Options? These 11 Key Starter Tips will keep you on the right path. What are Stock Options, Calls, Puts, Expiry… and much more.

This Article, Video, and Podcast cover important knowledge of Trading Stock Options:

  • How Stock Options Trading Works & Risks & Rewards?
  • What is the Difference between Stocks vs Options?
  • Included are my Top 11 Tips and Mistakes to avoid.

Recently I received an email from a registered student regarding Stock Options.

He asked me
“Do you have a system that can help me make money in Stock Options”

He had invested in training, but the training was mostly about how to follow a specific stock options system.

My reply was:

“My advice to you is to invest in your education so you can truly understand how to evaluate stocks and how to make decisions on the future direction of a stock. Also before you use options you need to be able to make money with regular stocks.

Options have risks (time is always against you) and you need to be able to judge the direction of the stock market as well as the direction of an individual stock.”

What are Stock Options?

Stock Options share some similarities with futures contracts and with normal stocks, but they are inherently different. Options are simply a contract, you do not own the underlying stock that determines the value of your options contract. Unlike stocks which you can hold indefinitely, options contracts all have an expiry date, and the closer to the expiry date you get the less your option is worth.

As you do not actually own the stock only a promise to pay the difference between the stock price now and the stock price at some point in the future you will see that the options contract cost as little a 2% to 20% of the cost of owning the stock.

Stock Options are simply a vehicle to achieve a goal. For those people who cannot use leverage to increase their total investment pot, Options are a cheap and effective way to leverage your invested capital.

The best way to understand options is to run through an example.

Stock Options Versus Stocks

For example. You have $1,000 to invest.

Strategy 1 – Buy the Stocks

You could buy 5 shares of Amazon Inc. (Ticker:AMZN) at $200 per share.

Total Costs $1000

If Amazon moved up 10% over the next 2 months to $220.

Your profit would be ($220 — $200) = $20 per share. 5 Shares * $20 = $100

Strategy 2 – Buy Options on the Stock

You could by one “At the Money Call Contract” for AMZN with a strike price of 200 and an expiry date of May 21 2020. The contract value is $10 per share. Because you will control 100 shares with each contract and you buy one contract, your costs for the trade are $1000.

In options speak:

  • 1 contract means you will have control over 100 shares of AMZN
  • At the money means the strike price of $200 per share is equal to the actual stock price.
  • Strike Price is the point at which the option will have a value (apart from the time value)
  • Expiry Date is the date at which the option contract expires and loses all value.

In the same scenario as above the stock price moves 10% to $220. The difference in price is $20 per share. The contract was at a strike price of $200, therefore $220 — $200 = $20 profit per share.

Theoretical profit would be 100 * $20 = $2000. A $2000 gain from a $1000 investment. This means a gain of 200%.

I say theoretically because when you buy an option the clock starts ticking on the time value. If the stock price took until the final month before expiry to move to $220, then you would have lost all of the time value of the contract which could reduce your profits. However, if the stock had moved 10% in a single day you would have secured almost all of the 200% and also kept much of the time value in the stock.

What are the risks of options, compared to simply buying the stock?

If the stock price moves against you, you can lose the entire investment. With stocks this is quite rare, stocks rarely move to zero unless the company goes bankrupt.

If the stock price does not move at all in the time period, your investment can also expire worthlessly.

The stock needs to move in the direction you place the bet to make a profit. If the stock price moves strongly your profits can be quite large.

Strategy 3 – Shorting a stock using options.

Using the exact same scenario but instead of us expecting the stock to increase in value we expect it to decrease.

AMZN has a current stock price of $200

You could by one “At the Money Put Contract” for AMZN with a strike price of 200 and an expiry date of May 21 2020. The contract cost $10 per share and there are 100 shares in a contract. Cost of investment is $1000.

In options speak:

  • 1 contract means you will have control over 100 shares of AMZN
  • “At the money” means the strike price of $200 per share has already been reached.
  • Strike Price is the point at which the option will have a value (apart from the time value)
  • Expiry Date is the date at which the option contract expires and loses all value.

In this scenario, the stock loses 10% in value to $180. The difference in price is now $20 per share. The contract was at a strike price of $200, therefore $200 — $180 = $20 profit per share.

Theoretical profit would be 100 * $20 = $2000. This means a gain of 200%.

Trading Stock Options Strategies

Stock Options are simply a vehicle to achieve a goal. For those people who cannot use leverage to increase their total investment pot, Options are a cheap and effective way to leverage your invested capital.

For example. I have $1,000 to invest.

Strategy 1 — Buy the Stocks

I could buy 5 shares of AMZN at $198 per share. Total Costs $990 + trade costs.

If Amazon (Ticker: AMZN) moved up 5% over the next 2 months to $207.90.

My profit would be $9.90 per share = $49.50

Strategy 2 — Buy Options on the Stock

I could buy 1 Out of the Money Call Contract for AMZN with a strike price of 200 and an expiry date of May 21 2020

In options speak:

  • 1 contract means I will have control over 100 shares of AMZN
  • Out of the money means the strike price of $200 per share has not been reached
  • Strike price is the point at which the option will have a value (apart from the time value)
  • Expiry Date is the date on which the option Contract expires and loses all value.

In the same scenario as above the stock price moves 5% to $207.90. The difference in price is $9.90 per share.

Theoretical profit would be 100 X 9.90 = $990. This means a gain of 100%.

I say theoretically because when you buy an option the clock starts ticking on the time value. If the stock price took 2 months to move to $207.90, then you would have lost all of the time value of the contract which would dramatically reduce your profits. However, if the stock had moved 5% in 1 day you would have secured almost all of the 100%.

What are the risks of Options compared to simply buying the stock?

If the stock price moves against you, you can lose the entire investment. With stocks, this is quite rare. If the stock price does not move at all in the time period, your investment can also expire worthlessly.

So in order to share some of my experiences with Options, I have created this Top 10 Tips

11 Core Tips for Stock Options Trading Success

Tip 1 — Understand Technical Analysis

Before trading a single Stock Options Contract you need to understand Technical Analysis. Not only that, you must have a strategy that pays off. This means you must have already developed a profitable stock market strategy through which you make a profit. If you cannot make money in stocks, then you will lose all your money quicker with options.

Tip 2 — Understand Fundamental Analysis

The fundamentals of a stock do have an impact on the direction of a stock. You need to know what makes a company a good investment and what makes it a bag of garbage. Do not bet against the fundamentals

Tip 3 — Time Counts Against You

You need to be sure before placing an Options Contract that the stock is going to move before the contract expires. You will look for more volatile stocks or at least stocks with a strong trend and increasing volume.

Tip 4 — In the Money Options, Out of the Money Options

Understand the additional costs of buying an option in the money as opposed to out of the money. When you buy an “In the Money Option” it means there is already some intrinsic value in the contract. This you will pay for in the contract price. Alternatively “Out of the Money Options” are cheaper, but it does mean that the stock price has further to move before the strike price is hit and the option’s intrinsic value is improved.

Tip 5 — Understand Calls & Puts

A Call Contract means you expect the stock price to increase and therefore seek a profit relating to the increase. When you buy a PUT Option it means you expect the stock price to fall and therefore realize a profit based on the decrease. This is rather like shorting a stock. You need to be sure of the direction of the stock.

Tip 6 — Buying Calls & Puts

If you are new to Stock Options Contracts you really need to be a Buyer of Contracts. In this way, you limit your risk to the amount you have bet on the contract. Unless you have expert professional skills you should only be a buyer of contracts.

Tip 7 — Selling Calls and Puts — Don’t Do It

If you are the seller of an Options Contract you have the benefit that time is on your side. Your goal is that the option expires worthless. Your reward is simply the value you get from the Contract you have underwritten. However Beware, as a seller of contracts you are taking huge risks, because you will need to pay out an almost unlimited amount if the stock skyrockets and you sold a Call Contract. Also if the stock price plummets and you sold a Put Contract you will also have huge liabilities.

Tip 8 — Don’t Get Too Complex

When you attend a seminar on stock options they will fill your head with all sorts of complex strategies like Vertical Spreads, Straddles, Bull Spreads, Bear Spreads and Box Spreads. If you make your trading complex you will not make any money. Keep it simple.

Tip 9 — Liquidity Matters

Before buying any Options check what the open interest is. This means try to find out if there is a liquid market in the contract. There is nothing worse than buying an Options Contract and then you have the shock that it is immediately almost worthless because no one is trading it and no one wants to buy it.

Tip 10 — Profit Volatility

Be ready to see some serious fluctuation in the profits or loss on an option. Sometimes I see wild swings in potential returns. An option can show a 25% profit in a few minutes, only to show a 20% loss a few hours later. An option is a leveraged investment that magnifies your gains and losses.

Tip 11 — Cash Allocation

Do not place your entire investment pot on any single Options Contract. Use only a portion of your money on options and of that portion do not invest more than 10% or 20% in any one contract. Remember if your contracts expire worthlessly and you lose all your money, then you have no more chips and you have to leave the table. You do not want that.

Stock Options Summary

Options are a complex instrument, but the more you understand them the more they make sense. With experience, you will see that they are an incredibly flexible investment tool. However, before even thinking about trading options you will need to understand how to pick stocks, evaluate the market direction and formulate a strategic systematic approach to investing.

Options are incredibly volatile and can very quickly lose your entire investment. Options are a numbers game and should only be used by advanced traders who have received specialist training in the topic.

Options are a great tool for magnifying your rewards, but you really need to be a successful stock trader before investing in Options. Learn how to make money in stocks before you use any leverage on your portfolio. Try the Liberated Stock Trader PRO Training before you research Trading Options.

Listen to Our Stock Options Podcast

Podcast 009 — Stock Options Trading Top 11 Tips

  • Published: Sun, 25 Mar 2020 23:00:00 GMT
  • Duration: 00:09:54

1 COMMENT

That’s good to know that a stock option means you have a contract rather than owning the stock. My husband wants to start doing trading and investing, so I’m looking into different ways he can. We’ll have to see if he can be trained in this to better understand how this works and how to make a profit.

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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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