The Extensive and Essential Options Trading

Guide
• Options as Derivatives
• Call and Put Options
• An Example of a Call Option
• An Example of a Put Option
• Options Obligations
• Buying and Selling Calls and Puts
• Options Terminology
• Why Use Options
• Combinations
• How Options Work
• Types of Options
• Options Exchanges
• How to Read An Options Table
• Options Spreads
• Long Calls/Puts, Straddles, and Strangles
• Call/Put Spreads and Butterflies
• Options Risks
• Meet the Greeks
• Conclusion

Options may seem overwhelming, but they're easy to understand if you know a
few key points. Investor portfolios are usually constructed with several asset
classes. These may be stocks, bonds, ETFs, and even mutual funds. Options are
another asset class, and when used correctly, they offer many advantages that
trading stocks and ETFs alone cannot.

Options can be purchased like most other asset classes with brokerage
investment accounts.

Options are powerful because they can enhance an individual’s portfolio. They
do this through added income, protection, and even leverage. Depending on the
situation, there is usually an option scenario appropriate for an investor’s goal. A
popular example would be using options as an effective hedge against a
declining stock market to limit downside losses. Options can also be used to
generate recurring income. Additionally, they are often used for speculative
purposes such as wagering on the direction of a stock.

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Alison Czinkota {Copyright} Investopedia, 2019.
The best way to think about options is this:

“Options give you options.”

There is no free lunch with stocks and bonds. Options are no different. Options
trading involves certain risks that the investor must be aware of before making a
trade. This is why, when trading options with a broker, you usually see a
disclaimer similar to the following:

Options involve risks and are not suitable for everyone. Options trading can be
speculative in nature and carry substantial risk of loss.

Options as Derivatives
Options belong to the larger group of securities known as derivatives. This word
is often associated with excessive risk-taking and having the ability to bring down
economies. Even Warren Buffett has referred to derivatives as “weapons of mass
destruction.” That perception, however, is really overblown.

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All “derivative” means is that its price is dependent on, or derived from the price
of something else. Think of it this way: wine is a derivative of grapes; ketchup is a
derivative of tomatoes; a stock option is a derivative of a stock.

Options are derivatives of financial securities—their value depends on the price

of some other asset. That is essentially what the term, derivative, means. There
are many different types of securities that fall under the label of derivative,
including calls, puts, futures, forwards, swaps (of which there are many types),
and mortgage-backed securities, among many others. In the 2008 crisis,
mortgage-backed securities and a particular type of swap caused all the trouble.
Options were largely blameless.

KEY TAKEAWAYS

• An option is a contract giving the buyer the right but not the obligation to
buy or sell an underlying asset at a specific price on or before a certain
date.
• Options are derivatives because they derive their value from an underlying
asset.
• A call gives the holder the right to buy an asset at a certain price within a
specific period of time; a put gives the holder the right to sell an asset at a
certain price within a specific period of time.
• There are four types of participants in options markets: buyers of calls,
sellers of calls, buyers of puts, and sellers of puts.
• The price at which an underlying stock can be purchased or sold is called
the strike price.
• The total cost of an option is called the premium, which is determined by
factors including the stock price, strike price and time value remaining until
expiration.
• A stock option contract typically represents 100 shares of the underlying
stock.
• Investors use options for income, to speculate, and to hedge risk.
• Option prices are determined by the Greeks, which allow for an option’s
risk to be understood and evaluated.
If you know how options work, and how to use them appropriately, you can have
a real advantage in the market. Most importantly, options can allow you to put the
odds in your favor. If using options for speculation doesn't fit your style, no
problem—you can use options without speculating.

Even if you decide never to use options, it is still important to understand how
companies you invest in use them. For instance, they might hedge foreign-
exchange risk, or give employees potential stock ownership in the form of stock

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options. Most multi-national corporations today use options in some form or
another.

Call and Put Options

Options are a type of derivative security. An option is a derivative because its
price is intrinsically linked to the price of something else. Remember: “options
give you options.”

If you buy an options contract, it grants you the right, but not the obligation to buy
or sell an underlying asset at a set price on or before a certain date. A call
option gives the holder the right to buy a stock and a put option gives the holder
the right to sell a stock.

Think of a call option as a down-payment for a future purpose.

An Example of a Call Option

A potential homeowner sees a new development going up. That person may
want the right to purchase a home in the future, but will only want to exercise that
right once certain developments around the area are built. For instance, will there
be a school going up soon? Or will there be a garbage dump coming? These
circumstances would affect their decision to buy the home.

The potential home buyer would benefit from the option of buying or not. Imagine
they can buy a call option from the developer to buy the home at say $400,000 at
any point in the next three years. Well, they can—you know it as a non-
refundable deposit. Naturally, the developer wouldn’t grant such an option for
free. The potential home buyer needs to contribute a down-payment to lock in
that right.

With respect to an option, this cost is known as the premium. It is the price of the
option contract. In our home example, the deposit might be $20,000 that the
buyer pays the developer. Let’s say two years have passed, and now the
developments are built and zoning has been approved. No garbage dump is
coming nearby. The home buyer exercises the option and buys the home for
$400,000 because that is the contract purchased.

The market value of that home may have doubled to $800,000. But because the
down payment locked in a pre-determined price, the buyer pays $400,000. Now,
in an alternate scenario, say the zoning approval doesn’t come through until year
four. This is one year past the expiration of this option. Now the home buyer must
pay market price because the contract has expired. In either case, the developer
keeps the original $20,000 collected.

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Call Option Basics

An Example of a Put Option

Now, think of a put option as an insurance policy. If you own your home, you are
likely familiar with purchasing homeowner’s insurance. A homeowner buys a
homeowner’s policy to protect their home from damage. They pay an amount
called the premium, for some amount of time, let’s say a year. The policy has a
face value and gives the insurance holder protection in the event the home is
damaged.

What if, instead of a home, your asset was a stock or index investment?
Similarly, if an investor wants insurance on his/her S&P 500 index portfolio, they
can purchase put options. An investor may fear that a bear market is near and
may be unwilling to lose more than 10% of their long position in the S&P 500
index. If the S&P 500 is currently trading at $2500, he/she can purchase a put
option giving the right to sell the index at $2250, for example, at any point in the
next two years.

If in six months the market crashes by 20% (500 points on the index), he/she has
made 250 points by being able to sell the index at $2250 when it is trading at
$2000—a combined loss of just 10%. In fact, even if the market drops to zero,
the loss would only be 10% if this put option is held. Again, purchasing the option
will carry a cost (its premium), and if the market doesn’t drop during that period,
the maximum loss on the option is just the premium spent.

Put Option Basics

Options Obligations
First, when you buy an option, you have a right but not an obligation to do
something with it. For stocks and many options on futures, it’s not required to
exercise your right to buy or sell stock by expiration. However, if your option has
value at expiration, in general, your broker will automatically exercise the option.
In our put example above, if the S&P 500 fell to zero at expiration, the 2250 put is
worth 2250. At expiration your put option would settle for the cash value, causing
a large gain on the hedge. Keep in mind that stocks are physically settled. Now,
back to our put example: if the S&P 500 went up to 3000 at expiration, your 2250
put is worthless.

Second, the most you can lose when buying an option contract is the premium
spent. This is an attractive trait for many. Limited risk allows option buyers to
sleep at night.

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Third, an option is a contract on an underlying asset. Its price is derived from the
underlying asset’s price. That’s why options are derivatives. In this tutorial, the
underlying asset will typically be a stock or stock index, but as mentioned,
options are actively traded on all sorts of financial securities, such as bonds,
foreign currencies, commodities, and yes, even other derivatives!

Buying and Selling Calls and Puts

There are four things you can do with options:

1. Buy calls
2. Sell calls
3. Buy puts
4. Sell puts

Buying a stock gives you a long position. Buying a call option gives you a
potential long position in the underlying stock. Short-selling a stock gives you a
short position. Selling a naked or uncovered call gives you a potential short
position in the underlying stock.

Buying a put option gives you a potential short position in the underlying stock.
Selling a naked, or unmarried, put gives you a potential long position in the
underlying stock. Keeping these four scenarios straight is crucial.

People who buy options are called holders and those who sell options are
called writers of options. Here is the important distinction between holders and
writers:

1. Call holders and put holders (buyers) are not obligated to buy or sell. They
have the choice to exercise their rights. This limits the risk of buyers of
options to only the premium spent.
2. Call writers and put writers (sellers), however, are obligated to buy or sell if
the option expires in-the-money (more on that below). This means that a
seller may be required to make good on a promise to buy or sell. It also
implies that option sellers have exposure to more, and in some
cases unlimited, risks. This means writers can lose much more than the
price of the options premium.

Options Terminology
To really understand options, you need to know the options market terminology.

The strike price of an option contract is the price at which an underlying stock
can be bought or sold. This is the price a stock price must go above (for calls) or
go below (for puts) before a position can be exercised for a profit. This must

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occur on or before the expiration date in order to be in-the-money. In our
example above, the strike price for the S&P 500 put option was 2250. The index
had to fall below 2250 on or before expiration to be exercised for a profit.

The expiration date, or expiry, of an option is the precise date that the option
contract terminates.

A listed option is an option that is traded on a national options exchange such as

the Chicago Board Options Exchange (CBOE). Listed options have fixed strike
prices and expiration dates. Each listed option represents 100 shares of stock
(known as 1 contract).

For call options, the option is in-the-money if the share price is above the strike
price. For example:

ABC April 50 Call. ABC stock is trading at $55. The Call is $5 in-the-money.

A put option is in-the-money when the share price is below the strike price. For
example:

ABC April 50 Put. ABC stock is trading at $45. The Put is $5 in-the-money.

The amount by which an option is in-the-money is also referred to as its intrinsic

value. For example:

ABC April 50 Call. ABC stock is trading at $55. The Call is $5 in-the-money and
also has $5 of intrinsic value.

An option is out-of-the-money if the price of the underlying remains below the

strike price (for a call), or above the strike price (for a put). An option is at-the-
money when the price of the underlying is at or very close to the strike price. For
example:

ABC April 50 Call. ABC stock is trading at $45. The Call is out-of-the-money and
also has no intrinsic value.

ABC April 50 Put. ABC stock is trading at $55. The Put is out-of-the-money and
also has no intrinsic value.

ABC April 50 Call. ABC stock is trading at $50. The Call is at-the-money and also
has no intrinsic value.

ABC April 50 Put. ABC stock is trading at $50. The Put is at-the-money and also
has no intrinsic value.
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Remember, the total cost (the price) of an option contract is called the premium.
This price is determined by a few factors, including:

• stock price
• strike price
• time remaining until expiration (time value)
• volatility

Although employee stock options aren't available for everyone to trade, they are
still a type of call option. Many companies use stock options as a way to attract
and to keep talented employees, especially management. They are similar to
regular stock options in that the holder has the right but not the obligation to
purchase company stock. The employee stock option contract, however, exists
only between the holder and the company. It typically cannot be exchanged with
anybody else. A listed option however, is a contract between two parties that is
completely unrelated to the company and can be traded freely.

Why Use Options

Speculation: Speculation is a wager on future price direction. A speculator might
think the price of a stock will go up, perhaps based on fundamental analysis or
technical analysis. A speculator might buy the stock or buy a call option on the
stock. Speculating with a call option—instead of buying the stock outright—is
attractive to some traders since options provide leverage. An out-of-the
money call option may only cost a few dollars or even cents compared to the full
price of a $100 stock.

Hedging: Options were really invented for hedging purposes. Hedging with
options is meant to reduce risk at a reasonable cost. Here, we can think of using
options like an insurance policy. Just as you insure your house or car, options
can be used to insure your investments against a downturn. Critics of options
may say “if you are so unsure of your stock pick that you need a hedge, you
shouldn't make the investment.”

In reality, there is plenty of evidence that hedging strategies can be useful. This
is especially true for large institutions. The individual investor can also benefit
from hedging. Imagine that you want to buy technology stocks. But you also want
to limit losses. By using put options, you could limit your downside risk and enjoy
all the upside in a cost-effective way. For short sellers, call options can be used
to limit losses if wrong—especially during a short squeeze.

Spreads
Spreads use two or more options positions of the same class. They combine
having a market opinion (speculation) with limiting losses (hedging). Spreads

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often limit potential upside as well. Yet these strategies can still be desirable
since they usually cost less when compared to a single options leg. Vertical
spreads involve selling one option to buy another. Generally, the second option is
the same type and same expiration, but different strike. Spreads really show the
versatility of options. A trader can construct a spread to profit from nearly any
market outcome. This even includes markets that don’t move up or down. We will
talk more about basic spreads later in this tutorial.

01:28

Spread

Combinations
Combinations are trades constructed with both a call and a put. There is a
special type of combination known as a “synthetic.” The point of a synthetic is to
create an options position that behaves like an underlying asset, but without
actually controlling the asset. For example, if you buy an at-the-money call and
simultaneously sell an at-the money put on stock XYZ with the same expiration
and strike, you have created a synthetic long position in XYZ stock. You don’t
actually own XYZ because you never bought it. But the combination of your long
call and short put behaves almost exactly like owning stock.

Why not just buy the stock? Maybe some legal or regulatory reason restricts you
from owning it. But you may be allowed to create a synthetic position using
options. A synthetic might also be useful if the underlying asset is something like
an index that is difficult to recreate from its individual components.

How Options Work

An option is the potential to participate in a future price change. So, if you own a
call, you can participate in the uptrend of a stock without owning the stock. You
have the option to participate.

In terms of valuing option contracts, it is essentially all about determining the

probabilities of future price events. The more likely something is to occur, the
more expensive an option would be that profits from that event. For instance, a
call value goes up as the stock (underlying) goes up. This is the key to
understanding the relative value of options.

Let’s look at an example of a call option on International Business Machines

Corp. (IBM) with a strike price of $200 expiring in three months. IBM is currently
trading at $175. Remember, owning the call option gives you the right, but not
the obligation, to purchase 100 shares of IBM at $200 at any point in the next

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three months. If the price of IBM rises above $200 at any point within three
months, then the call option will become in-the-money.

The less time there is until expiry, the less value an option will have. This is
because the chances of a price move in the underlying stock diminishes as we
draw closer to expiry. This is why an option is a wasting asset. If you buy a one-
month option that is out of the money, and the stock doesn’t move, the option
becomes less valuable with each passing day. Since time is a component to the
price of an option, a one-month option is going to be less valuable than a three-
month option. This is because with more time available, the probability of a price
move in your favor increases, and vice versa.

Accordingly, the same option strike that expires in a year will cost more than the
same strike for one month.

This wasting feature of options is a result of time decay. The same option will be
worth less tomorrow than it is today if the price of the stock doesn’t move.

04:23

Option

Let’s go back to our IBM three-month call example. The most important factor
that increases the value of your call is the price of IBM stock rising closer to
$200. The closer the price of the stock moves towards the strike, the more likely
the call will expire in-the-money. Simply stated, as the price of the underlying
asset rises, the price of the call option premium will also rise. Alternatively, as the
price goes down—and the gap between the strike price and the underlying asset
price widens—the option will lose value. Similarly, if the price of IBM stock stays
at $175, the $190 strike call will be worth more than the $200 strike call, because
the chance of IBM rising to $190 is greater than the chance of reaching $200.

Volatility also increases the price of an option. This is because uncertainty

pushes the odds of an outcome higher. If the volatility of the underlying asset
increases, larger price swings increase the possibilities of substantial moves both
up and down. Greater price swings will increase the chances of an event
occurring. Therefore, the greater the volatility, the greater the price of the option.
Options trading and volatility are intrinsically linked to each other in this way.

With this in mind, let’s consider this hypothetical example. Let's say that on May
1, the stock price of Cory's Tequila Co. (CTQ) is $67 and the premium (cost) is
$3.15 for a July 70 Call. Seeing only “July” with no date indicates that the
expiration is the third Friday of July. The strike price is $70. The total price of the

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call contract is $3.15 x 100 = $315. In reality, you’d need to consider
commissions, but we'll ignore them for this example.

On most U.S. exchanges, a stock option contract is the option to buy or sell 100
shares; that's why you must multiply the contract premium ($3.15) by 100 to get
the total amount you’ll have to spend to buy the call ($315). The strike price of
$70 means that the stock price must rise above $70 before the call option has
intrinsic value. Furthermore, because the contract is $3.15 per share, the break-
even price at expiration would be $73.15 (Strike price + premium).

Three weeks later, the stock price has risen to $78. The call option contract has
increased in value along with the stock price and is now worth $8.25 x 100 =
$825. Subtract what you paid for the contract, and your profit is ($8.25 - $3.15) x
100 = $510. The call has $8.00 of intrinsic value. Remember that for calls, stock
price minus strike = intrinsic value. $78 - $70 = $8.00. The remaining $0.25 is
time value (more on this later).

In this scenario, you’ve almost doubled your money in just three weeks! You
could sell your call option, which is called "closing your position," and take your
profits—unless, of course, you think the stock price will continue to rise. For the
sake of this example, let's say we let it ride.

By the expiration date, the price of CTQ drops down to $62. Because this is less
than our $70 strike call option and there is no time left, the option contract
expires worthless. We have no position in the stock and we have only lost the
original premium we spent of $315.

WHAT HAPPENED TO OUR OPTION INVESTMENT

May 1 May 21 Expiry Date
Stock Price $67 $78 $62
Option Price $3.15 $8.25 worthless
Contract Value $315 $825 $0
Paper Gain/Loss $0 $510 -$315
So far, we've talked about the option holder having the right to buy or sell
(exercise) the underlying stock. While this is technically true, a majority of options
are never exercised. In our example, you could make money by exercising at $70
and then selling the stock back in the market at $78 for a profit of $4.85 a share
($8.00 stock gain minus $3.15 premium). You could also keep the stock, knowing
you were able to buy it at a discount to the present value. However, the majority
of the time, holders choose to take their profits by trading out (closing out) their
position. This means that option holders sell their options in the market, and
writers buy their positions back to close. According to the CBOE , only about

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10% of options are exercised, 60% are traded (closed) out, and 30% expire
worthless.

Now is a good time to dig deeper into pricing options. In our example, the
premium (price) of the option went from $3.15 to $8.25. These fluctuations can
be explained by intrinsic value and extrinsic value, which is also known as time
value. An option's premium is the combination of its intrinsic value and its time
value. Intrinsic value is the in-the-money amount of an options contract, which,
for a call option, is the amount above the strike price that the stock is trading.
Time value represents the added value an investor has to pay for an option
above the intrinsic value. This is the extrinsic value, or time value. So, the price
of the option in our example can be thought of as the following:

Premium = Intrinsic Value + Time Value

$8.25 $8.00 $0.25
In real life, options almost always trade at some level above their intrinsic value,
because the probability of an event occurring is never absolutely zero, even if it is
highly unlikely.

A brief word on options pricing. The market assigns a value to an option based
on the likely outcome relative to the underlying asset, as in the example above.
But in order to put an absolute price on an option, a pricing model must be used.
The most well-known model is the Black-Scholes-Merton model, which was
derived in the 1970s, and for which the Nobel Prize in economics was awarded.
Since then, other models have emerged, such as binomial and trinomial tree
models, which are commonly used by professional options traders. In real life,
options almost always trade at some level above their intrinsic value, because
the probability of an event occurring is never absolutely zero, even if it is highly
unlikely.

Types of Options
American and European Options
Now that we’ve talked about the differences between calls and puts, let’s explore
some other differences of categorizing options contracts. American options can
be exercised at any time between the date of purchase and the expiration date.
The example of Cory's Tequila Co. shows the use of an American option. Most
exchange-traded options are American. European options are different from
American options in that they can only be exercised at the end of their lives on
their expiration date. The distinction between American and European options
has nothing to do with geography, only with early exercise. Many options on
stock indexes are of the European type. Because the right to exercise early has
some value, an American option typically carries a higher premium than an

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otherwise identical European option. This is because the early exercise feature is
desirable and commands a premium.

Options Expiration & Liquidity

Options can also be categorized by their duration. Short-term options are those
that expire generally within a year. Long-term options with expirations greater
than a year are classified as long-term equity anticipation securities, or LEAPs.
LEAPS are identical to regular options, they just have longer durations. Although
they aren’t available on all stocks, LEAPS are available on most widely held
issues. You should know that LEAPS can be less liquid than shorter term
options, so they are not ideal for short-term trading.

Options can also be distinguished by when their expiration date falls.

Traditionally, listed options have expirations on the third Friday of the month.
However due to increased demand, sets of options now expire weekly on each
Friday, at the end of the month, or even on a daily basis. Index and ETF options
also sometimes offer quarterly expiries.

Options Exchanges
Options traded on exchanges are called listed options. In the U.S., there are a
number of exchanges, both physical and electronic, where options are traded.
For U.S. stocks, there are 15 options exchanges on the last count. Options can
also be traded directly between counterparties with the use of an exchange or an
ISDA agreement; these are known as over-the-counter (OTC) options. Often,
financial institutions will use OTC options to tailor specific outcome events that
are not available among listed options.

Market makers exist in order to provide liquidity to options markets. They are
required to “make” a two-sided market in an option if asked to quote. Market
makers, using theoretical pricing models, can take advantage of arbitrage by
exploiting theoretical mis-pricings between the options’ perceived value and its
market price.

The simple calls and puts we've discussed are sometimes referred to as plain
vanilla options. Even though the subject of options can be difficult to understand
at first, these plain vanilla options are as easy as it gets.

Because options are so versatile, there are many other types and variations of
options. When ordinary listed or OTC options won’t do, there are exotic options.
They are exotic because there might be a variation on the payoff profiles from the
plain vanilla options. Or they can become totally different products all together
with "optionality" embedded in them. For example, binary options have a simple
payoff structure that is determined if the payoff event happens regardless of the

13
degree. Other types of exotic options include knock-out, knock-in, barrier
options, lookback options, Asian options and Bermudan options. Again, exotic
options are typically for professional derivatives traders.

How to Read An Options Table

Trading volume in options has steadily increased over the years. This is because
more traders are embracing the benefits options offer. Electronic trading
platforms and information dissemination have helped the trend as well.

Some traders use options to speculate on price direction. Others hedge existing
or anticipated positions, and others still attempt to craft unique positions that offer
benefits not available to trading just the underlying stock, index or futures
contract. For example, one can profit from options if the price of the underlying
security doesn’t change at all.

Regardless of the objective, one of the keys to success is in picking the right
option, or a combination of options needed to create a position with the desired
risk-to-reward trade-off(s). As such, today's savvy options trader is typically
looking at more sophisticated information when it comes to options than they did
in the past.

More and more traders are finding option data through online sources. While
each source has its own format for presenting the data, the key components
generally include those listed in Figure 2 from Interactive Brokers. The variables
listed are the ones most commonly used by today’s options trader.

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Figure 2: September call options for MSFT.
The data provided in Figure 2 provides the following information:

Column 1 – Volume (VLM): This simply tells you how many contracts of a
particular option were traded during the latest session. Typically – though not
always – options with large volume will have relatively tighter bid/ask spreads, as
the competition to buy and sell these options is great.

Column 2 – Bid: The "bid" price is the latest price level at which a market
participant wishes to buy a particular option. What this means is that if you enter
a "market order" to sell the September 2018, 105 call, you would sell it at the bid
price of $3.55.

Column 3 – Ask: The "ask" price is the latest price offered by a market
participant to sell a particular option. What this means is that if you enter a
"market order" to buy the September 2018, 105 call, you would buy it at the ask
price of $3.65.

Buying at the bid and selling at the ask is how market makers make their living.
Column 4 – Implied Bid Volatility (IMPL BID VOL): Implied volatility can be
thought of as the future uncertainty of price direction and speed. Think of a

15
situation in which a future outcome, like an earnings event, is very uncertain. This
would be a situation with high implied volatility. When we have an unclear idea of
the future direction of a stock, uncertainty is high and so is implied volatility.

This value is calculated by an option-pricing model such as the Black-Scholes

model, and represents the level of expected future volatility based on the current
price of the option. It also incorporates other known option-pricing variables
(including the amount of time until expiration, the difference between the strike
price and the actual stock price and a risk-free interest rate). The higher the
Implied Volatility (IV), the more time premium is built into the price of the option,
and vice versa. If you have access to the historical range of IV, you can
determine if the current level of extrinsic value is presently on the high end (good
for writing options) or low end (good for buying options).

Column 5 – Open Interest (OPTN OP): This number indicates the total number
of contracts of a particular option that have been opened. Open interest
decreases as open trades are closed.

Column 6 – Delta: Delta can be thought of as probability. For instance, a 30-

delta option has roughly a 30% chance of expiring in-the-money. Technically,
Delta is a Greek value derived from an option-pricing model, and it represents
the "stock-equivalent position" for an option. The delta of a call option can range
from 0 to 100 (and for a put option, from 0 to -100). The reward/risk
characteristics associated with holding a call option with a delta of 50 is
essentially the same as holding 50 shares of stock. It also has a roughly 50%
chance of expiring in the money. If the stock goes up one full point, the option will
gain roughly one half a point (50%). The further an option is in-the-money, the
more the position acts like a stock position. In other words, as delta approaches
100 (100% probability of expiring in-the-money), the option trades more and
more like the underlying stock. So, an option with a 100-delta would gain or lose
one full point for each one dollar gain or loss in the underlying stock price.

(For more, check out Using the Greeks to Understand Options.)

Column 7 – Gamma (GMM): Think of gamma as the speed the option is moving
in or out-of-the money. Gamma can also be thought of as the movement of the
delta. So gamma can answer the question: how fast is my option moving towards
becoming an in-the-money option? Technically, gamma tells you how many
deltas the option will gain or lose if the underlying stock rises by one full point.
For example, let’s say we bought the MSFT September 2018 105 call for $3.65.
It has a delta of 65.70. In other words, if MSFT stock rises by a dollar, this option
should gain roughly 65.7 cents in value. If that happens, the option will gain 6.5
deltas (the current gamma value) and would then have a delta of 72.2. From

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there another one point gain in the price of the stock would result in a price gain
for the option of roughly $0.722. So, gamma helps us measure the speed of the
movement of the option’s delta.

Column 7 – Vega: Vega is a Greek value that indicates the amount by which the
price of the option would be expected to change based on a one-point change in
implied volatility. So looking once again at the MSFT September 2018 105 call, if
implied volatility rose one point – from 17.313% to 18.313%, the price of this
option would gain $0.123. This shows us why it is preferable to buy options when
implied volatility is low. You pay relatively less time premium, and a rise in IV will
inflate the price of the option. It is also better to write options when implied
volatility is high – more premium is available, and a decline in IV will decrease
the price of the option.

Column 8 – Theta: Options lose all time premium by expiration. "Time decay,”as
it is known, accelerates as expiration draws closer. When there’s no time left in
an option, there’s no more time value. At this point, the option either has intrinsic
value or zero value. Theta is the Greek value that indicates how much value an
option will lose with the passage of one day's time. At present, the MSFT
September 2018 105 call will lose $0.034 of value due solely to the passage of
one day's time, even if the option and all other Greek values remain
unchanged. Notice how quickly time decay eats away at an option’s value just
before expiry.

Figure 3: Time value as option nears expiration.

Column 9 – Strike: The "strike price" is the price at which the buyer of the option
can buy or sell the underlying security if he/she chooses to exercise the option. It
is also the price at which the writer of the option must sell or buy the underlying
security if the option is assigned to him/her.

Like the table for calls above, a table for the respective put options would be
similar, with two primary differences:

1. Call options are more expensive the lower the strike price is, while put
options are more expensive the higher the strike price is. With calls, option
prices decline as the strikes go higher. This is because each higher strike
price is less in-the-money (more out-of-the-money), so higher strike calls
contain less "intrinsic value" than the calls with lower strike prices.
2. With puts, it is just the opposite. As the strike prices increase, put options
become either less-out-of-the-money or more in-the-money and therefore
contain more intrinsic value. So, with puts, the option prices increase as
the strike prices rise.
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 3. For call options, the delta values are positive and are higher at lower strike
prices. For instance, on a $30 stock, a $20 call may have a 90 delta while
a $40 call may have a 10 delta. For put options, the delta values are
negative and are higher at higher strike prices. For instance, on a $30
stock, a $20 put may have a -10 delta while a $40 put may have a -90
delta. The negative values for put options come from the fact that they
represent a stock-equivalent position. Buying a put option is similar to
entering a short position in a stock, hence the negative delta value.

The level of sophistication of both options trading and the average options trader
have come a long way since trading in options began decades ago. Today's
option quote screen reflects these advances.

Options Spreads
Options spreads are a common strategy and involve buying and selling options
of the same or differing types, expirations, and strikes. You can also combine
different options strategies, known as combinations. In this section, we will
provide a very basic overview of the most common options spreads and
combinations.

Long Calls/Puts, Straddles, and Strangles

The simplest options position is a long call (or put) by itself. This position profits if
the price of the underlying rises (falls), and your downside is limited to loss of the
option premium spent. If you simultaneously buy a call and put option with the
same strike and expiration, you’ve created a straddle.

This position pays off if the underlying price rises or falls dramatically; however, if
the price remains relatively stable, you lose premium on both the call and the put.
You would enter this strategy if you expect a large move in the stock but are not
sure which direction.

Basically, you need the stock to have a move outside of a range. A similar
strategy betting on an outsized move in a security when you expect high volatility
(uncertainty) is to buy a call and buy a put with different strikes and the same
expiration—known as a strangle. A strangle requires larger price moves in either
direction to profit, but is also less expensive than a straddle. On the other hand,
being short either a straddle or a strangle (selling both options) would profit from
a market that doesn’t move much.

02:14

How to use Straddle Strategies

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Call/Put Spreads and Butterflies
A bull call spread, or bull call vertical spread, is created by buying a call and
simultaneously selling another call with a higher strike price and the same
expiration. The spread is profitable if the underlying asset increases in price, but
the upside is limited due to the short call strike. The benefit, however, is that
selling the higher strike call reduces the cost of buying the lower one. Similarly,
a bear put spread, or bear put vertical spread, involves buying a put and selling a
second put with a lower strike and the same expiration.

If you buy and sell options with different expirations, it is known as a calendar
spread, or time spread.

A butterfly consists of options at three strikes, equally spaced apart, where all
options are of the same type (either all calls or all puts) and have the same
expiration. In a long butterfly, the middle strike option is sold and the outside
strikes are bought in a ratio of 1:2:1 (buy one, sell two, buy one).

If this ratio does not hold, it is not a butterfly. The outside strikes are commonly
referred to as the wings of the butterfly, and the inside strike as the body. The
value of a butterfly can never fall below zero. An example of a butterfly would be
to go long a 70 call, short two 75 calls, and long an 80 call. The identical spread
could also be made with long the 70 put, short two 75 puts, and long an 80 put.
Being long a butterfly profits from a quiet market. Similar to a butterfly are
the condor, iron butterfly, and iron condor. The butterfly gets its name from the
shape of its profit-and-loss graph.

We addressed briefly how a synthetic position in the underlying can be created

from options. Combining options positions with the underlying can also produce
synthetic options. This has to do with what is known as put-call parity, where:

Call Price – Put Price = Underlying Price – Strike Price.

Rearranging this equation, we can create a synthetic long call for a given strike
price by buying a put and also buying the underlying. Similarly, a synthetic put is
a long call combined with going short the underlying. You can also create other
combination strategies that include a trade in the underlying, such as a collar or
risk reversal.

Options Risks
Because options prices can be modeled mathematically with a model such
as Black-Scholes, many of the risks associated with options can also be modeled
and understood. This particular feature of options actually makes them
arguably less risky than other asset classes, or at least allows the risks

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associated with options to be understood and evaluated. Individual risks have
been assigned Greek letter names, and are sometimes referred to simply as the
Greeks.

2:20
02:20

Using the Greeks to Understand Options

Meet the Greeks

Delta is the change in option price per unit (point) change in the underlying price,
and thus represents the directional risk. Delta is interpreted as the hedge ratio, or
alternatively, the equivalent position in the underlying security: a 100-delta
position is equivalent to being long 100 shares.

An easy way to think about delta is that it can represent the probability that an
option has of finishing in the money (a 40-delta option has a 40% chance of
finishing in the money). At-the-money options tend to have a delta near 50. Think
about it this way, if you buy a stock today, it has a 50% chance of going up and
50% chance of going down. In-the-money options typically have a delta greater
than 50, and out-of-the-money options are typically less than 50. Increasing
volatility or time to expiration, in general, causes deltas to increase.

Gamma measures the change in delta per unit (point) change in the underlying
security. The gamma shows how fast the delta will move if the underlying
security moves a point. This is an important value to watch, since it tells you how
much more your directional risk increases as the underlying moves. At-the-
money options and those close to expiration have the largest gammas. Volatility
has an inverse relationship with gamma, so as volatility increases the gamma of
the option decreases.

Theta measures the change in option price per unit (day) change in time. Also
known as time decay risk, it represents how much value an option loses as time
passes. Long-term options decay at a slower rate than near-term options.
Options near expiration and at-the-money have the highest theta. Additionally,
theta has a positive relationship with volatility, so as implied volatility increases,
theta also generally increases.

Vega measures the sensitivity of an option to volatility, represented as the

change in option price per unit (percent) change in volatility. If an option has a
vega of .2 and the implied volatility increases by 1%, the option value should
increase by $.20. Options with more time till expiration will have a higher vega

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value compared to those nearer to expiration. At-the-money options are most
sensitive to changes in vega.

Rho represents the option’s sensitivity to interest rate risk: the change in option
price per unit change in interest rates. A position with positive rho will be helped
by an increase in interest rates, and a negative rho will be helped by a decrease
in interest rates.

Conclusion
Options do not have to be difficult to understand once you grasp the basic
concepts. Options can provide opportunities when used correctly, and can be
harmful when used incorrectly. Please use this tutorial as it was intended—as a
starting point to learning more about options.

A recap:

• An option is a contract giving the buyer the right but not the obligation to
buy or sell an underlying asset at a specific price on or before a certain
date.
• Options are derivatives because they derive their value from an underlying
asset.
• A call gives the holder the right to buy an asset at a certain price within a
specific period of time.
• A put gives the holder the right to sell an asset at a certain price within a
specific period of time.
• There are four types of participants in options markets: buyers of calls,
sellers of calls, buyers of puts, and sellers of puts.
• Buyers are often referred to as holders, and sellers are also referred to as
writers.
• The price at which an underlying stock can be purchased or sold is called
the strike price.
• The total cost of an option is called the premium, which is determined by
factors including the stock price, strike price and time value remaining until
expiration.
• The premium of an option increases as the chances of the option finishing
in-the-money increases.

• A stock option contract typically represents 100 shares of the underlying

stock.
• Investors use options for income, to speculate, and to hedge risk.
• Spreads and synthetic positions highlight the versatility of options
contracts.

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• Employee stock options are different from listed options because they are
a contract between the company and the holder. (Employee stock options
do not involve any third parties.)
• The two main classifications of options are American and European.
Options can also be distinguished as listed/OTC or vanilla/exotic, among
other classification schemes.
• Long-term options are known as LEAPS.
• Option prices are determined by the Greeks, which allow for an option’s
risk to be understood and evaluated.

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