In this article, I will be explaining everything about Stock Options Trading.
This will be the 3rd part of my previous option series.
We’re going to go back to that analogy quite a bit in this chapter because thinking about options as insurance is the best way to understand the way they are priced now.
Understanding Option Strategies
Three factors will cause an options price to move around each day.
Once you understand how these three factors affect option prices daily, we will be able to dive into different strategies we can use to take advantage and profit from option price movements, and you know that’s where the fun starts.
Still, we have to lay the groundwork first and focus on understanding these three factors number one, the price of the underlying stock number two time to expiration, and number three, the volatility of the
underlying stock first, let’s talk about how the underlying stocks price will affect the price of its options.
Let’s think back to the basic definition of a put option. Buying a put option gives you the right to sell stock at an agreed-upon price on or before a particular date, and of course, the agreed-upon price is determined by the strike price.
Understanding By Examples
Right now, you can see twitter stock and its options that expire in 28 days.
Let’s say you own 100 shares of Twitter stock at 18 per share, you could buy the 18 strikes put option, and that would be like buying full coverage insurance, right if for some crazy reason twitter tanks, then your put option would allow you to sell your shares of stock at 18 per share right where you bought it even though the current market price is much lower than that and looking at the option pricing you can see that it would cost around 159 for the 18 strikes put option.
And of course, multiply that by 100, and the cost of one contract of this 18 strike put option would be about 159 dollars.
If you were to buy the 16 strikes put instead, you can see that it would cost you much less money.
It would cost around 75 dollars for one contract.
The reason it’s cheaper is that it would only ensure 16 per share worth of your investment rather than the total amount of 18 per share.
Now let’s look at an entirely different example. Let’s say you own the 120 strike call option on stock XYZ. You don’t own any stock, you own the call option, and this call option would, of course, give you the right to buy shares of XYZ stock at 120.
So what if the current stock price is at 125 per share? Well, if the current stock price is at 125 and you own an option that gives you the right to buy the stock at 120, then that option is going to be worth at least five dollars, right because if you exercise the option, you would have an immediate five-dollar per-share profit.
In this scenario, we would refer to this option as being in the money because it has value. It allows us to purchase the stock at a discount to the current market price, so again, this option is referred to as being in the money.
Now, one more scenario again, let’s say you own the 120 strike call option, but the stock is much lower this time, and it’s currently at 115.
If you own an option that gives you the right to buy the stock at 120, but the current stock price is below that at 115, assuming there’s no time left expiration, how much is this option going to be worth in this case right it’s going to be worthless because who in their right mind would want to exercise their right to buy the stock at 120 when they can simply purchase it at its current market price of 115.
In this scenario, we would refer to this option as being out of the money because the call option strike price is above the current stock price and therefore does not allow us to purchase the stock at a discount again.
This is referred to as out of the money.
Now I know this seems like a lot to keep up with and a lot of information to digest all at once, and of course, we’re going to recap all of this again at the end of the chapter for you to take notes.
The cool thing is if we look at an option chain, you can see that the in the money and out of the money options are highlighted in the money calls inputs have a bluish shaded background, and the out of money calls inputs to have an empty or black background.
So just one more time in the money, calls are calls with a strike price that is less than the current stock price, and the out of money calls with a strike price that is greater than the current stock price, and for puts, it’s the exact opposite.
Now, this is where it will start to come together. You’ll notice that the further in the money an option is, the more expensive it is.
This is because if an option allows you to purchase the stock at a more significant discount, it will be more valuable than an option that only allows you to purchase the stock at a slight discount.
Now here is the thing stock prices are constantly moving, so if you own a call option and the stock price goes up, that call option will increase in value because it is becoming more and more in the money.
Let me repeat because this is important if a stock’s price rises, then that stock’s call options will increase in value, and if you own a put option and the stock price falls.
That put option will increase in value now if you buy an option today and wonder what it will be worth at the expiration date.
It will simply be worth the difference between the stock price and the options strike price to put it
more straightforwardly, the option’s value will be determined by how far in the money it is.
This is also referred to as the intrinsic value of the option. An option will be worth its intrinsic value at the expiration date; to demonstrate this, let’s look at the options about to expire on Twitter, so these options have no time left.
The stock is currently trading at 1809, and if we look at the 17 strike call, we can see that it’s worth a dollar five by a dollar fourteen, so around one oh nine, the reason is that the 17 strike call would allow you to purchase the stock at a discount of a dollar and nine cents.
And if we look a little further in the money, you can see the 16 strike call is worth around 209. It says 215 on the screen because it’s so deep in the money, and the bid-ask spread is kind of broad, but its actual worth is around 209 because it would allow you to purchase the stock at a discount of two dollars and nine cents per share.
And remember if an option is out of the money, then it will be worthless at the expiration because nobody wants to purchase stock at a higher price than the current market value, and similarly out of the money puts will also be worthless because nobody wants to sell stock at a lower price than what it’s worth.
You can see that on these options here, all the out of the money options are worthless, so just to recap real quick at the expiration date in the money options will be worth the difference between the strike price and the stock price and all out of the money options will be worthless.
But let’s look at the options that are not yet about to expire. You can see that even the out-of-the-money options still have value, so if all out-of-the-money options will be worthless at the expiration date, why do they have value now? This leads us to our next point, which is time to expiration.
Let’s talk about how time will affect an options price. We’ve talked about how options are insurance, and of course, you have to pay money for this insurance now; the thing about insurance is you don’t get to pay a one-time payment and have insurance forever.
You have to pay month after month to keep your insurance, so the longer you have it, the more money you will have to pay options are the same way they have expiration dates for the same reason you have to pay monthly for car insurance if you want to ensure your car for six months it might cost you six hundred dollars.
Still, if you want to ensure it for 12 months, it might cost you 1200.
In the same way, an option with 60 days to expiration will have a higher price than the same option with only 30 days to expiration.
In the last section, you learn about the money and out of the money.
You learn that out-of-the-money options are options that have a strike price that does not allow you to purchase or sell the underlying stock at a better price than the current market price, so therefore the money options are worthless now.
This is only true if there is no time left on the option; let me explain right now you’re looking at Twitter, options that have zero days left expire this evening after the market closes, and you can see that the out-of-the-money options are at zero.
Now let’s look at the options that still have time left until they expire. We’re going to look at the options with 28 days to expiration.
You can see the out-of-the-money options with 28 days to expiration value, but if they don’t have value at the expiration, why do they have value now?
The answer is because stock prices move, and if there is still time left until expiration, then there is still a chance that the out of the money option could become in the money, so the reason these out of the money options have to value is that there is still time left for the stock to move around.
Think of it this way when you purchase car insurance, is it going to be worth the price you paid? Well, we don’t know, right? I don’t know if you’re going to get into a crash.
It could be worthless, or you could get into a crash, and you’ll be pleased that you had the insurance.
Now I realize that car insurance is required for all drivers, even if you know it’s overpriced.
However, the analogy still stands now you can see that the further out of the money an option is, the cheaper it is that’s because the likelihood of it being of any value is less than an option with a strike price that is closer to the current stock price right this stock is more likely to get to 20 per share within the next 28 days than it is to get to 25 dollars per share.
After all, it would have to make a huge move to get to 25, whereas it would only have to make a small move to get to 20.
So, therefore, the 25 strike call option will not cost that much money because it isn’t very likely that it will be of any value at expiration now you see the prices of these options with 28 days to expiration again.
Let’s take a look at what these option prices will look like. With zero-days to expiration, all of these out-of-the-money options are worthless, and the in-the-money options are worth the difference between the stock price and the strike price.
Since there is no time left, there is no time value left on these options.
This is also referred to as extrinsic value.
Extrinsic value refers to the amount by which an option’s price is greater than the intrinsic value.
Intrinsic value refers to the in-the-money portion of that option’s price okay, which may have sounded a little confusing.
So let me just show you a quick example. Remember we mentioned that these options that expire today don’t have any extrinsic value so let’s again go back to the options with 28 days to expiration.
Check out the 17 strike call option with 28 days.
The price of this option is 220, and the current stock price is 18.09.
So this 17 strike call option is a dollar and nine cents in the money, so its intrinsic value is 109, and the extrinsic value is just whatever has leftover.
In this case, the extrinsic value is 111, and remember at the expiration date, there will be no extrinsic value left on the options the value of this option at expiration will be whatever its intrinsic value is, so in practice, what does this mean for us?
Let’s say we bought this call option right now at 220.
We know that if twitter stock doesn’t move and trades sideways for the next 28 days, then this option is going to go from 220 gradually down to 109, and we learned in the last chapter that option prices have a
multiplier of 100, so in this case, we paid 220 dollars and sold it for 109 dollars, so our net loss would be 111 dollars, and the stock didn’t even move for us to have made money on this call option.
The Twitter stock would have had to move high enough for the intrinsic value to exceed the premium we paid for the option so, for example, we paid 220 for the 17 strike call for us to break even on the trade at expiration, the stock would have to be at 17 plus 220, which comes out to be 1920.
Twitter is currently at 1809, so it would have to move up to 1920 for us to break even. That’s why we kept saying to keep watching before you start buying calls on every stock you think is going to go up and puts on every stock you think is going to go down because even though it costs much less than trading the shares of stock, you’re going to have time decay against you so not only will the stock have to move in your favorite will have to move in your favor a significant amount for you to even breakeven options are constantly decaying as time passes.
This is precisely why we don’t trade options in this way.
We never buy options to guess the direction of the underlying stock, and we trade them in a way to take advantage of this time decay, and you’re going to learn these strategies later on in this course.
I want to avoid confusion quickly because an option’s extrinsic value or time value is gradually decaying, so if you buy this option today.
Twitter moves up to 1920 tomorrow, then you’re going to have a pretty decent profit because there will still be time value left on this option.
So your breakeven that we determined of 1920 is your breakeven at the expiration date.
If that confused, you don’t worry about if we’re going to touch more on this topic very soon. Still, I just wanted to clarify that you don’t have to hold an option to its expiration date, we can open and close the trade anytime before the expiration date.
Now, let’s recap what you’ve learned in this section expiration date options have expiration dates for the same reason you have to pay monthly for car insurance.
With that being said, you don’t have to hold an option to expiration. If you own an option, you can sell at any time before expiration at the current market price of the option and more time equals more money.
If you buy an option with 60 days to expiration, it will cost you more money than buying an option with only 30 days to expiration.
You’ll also learn about intrinsic and extrinsic value.
Intrinsic value simply refers to the in the money portion of an options price, and extrinsic value is just anything leftover extrinsic value can also be referred to as time value and remember if an option has no time left to expiration, meaning it’s about to expire, then it’s going to have no time value left on it it will simply be worth whatever its intrinsic value is.
And lastly, option prices are constantly decaying due to the passage of time, so if you are buying options, you will be fighting this decay which is why we recommend you finish this entire course before making your first options trade so you can learn other strategies to allow you to put yourself in a position to profit from this time decay.
It’s mighty once you learn how to do this. Let’s talk about volatility.
Most options traders learn what you learn in the first two sections, and they think that’s enough.
They just completely ignore this third factor, and then they wonder why they can’t figure out how to make any money trading options, so listen up because volatility is equally as important as the other two factors, if not more important, especially when learning how to make money trading options.
You have to understand volatility, and it’s not that complicated, so what is volatility is simply the magnitude of a stock’s price swings.
If a stock has high volatility, then that means it has large price swings, and if a stock has low volatility, then that means it has small price swings.
Now think about this if you own stock as an investment, then that stock’s volatility is a good measure of your risk; right if a stock has high volatility and it makes large price swings, then you are going to be exposed to more significant losses on that stock investment, so high volatility equals more risk for the stock investor.
Since there is more risk involved, options will be more expensive.
I know you’re probably sick of the insurance analogy by now, but let’s think of options as insurance again. Suppose you buy an option as a way to protect your stock investment.
In that case, you are paying the option seller to take on your risk, and if your risk is higher, why would the option seller not demand more money right if they are assuming more risk then they are going to want to be paid for that let me explain.
You are an insurance company providing life insurance for two different people.
The first person is overweight, smokes a pack a day, and has a severe medical condition.
The second person is healthy, exercises regularly, and has no signs of any life-threatening medical conditions.
Who do you think is going to have to pay more for life insurance, precisely the person who is at more risk of dying now think of this person as a stock with high volatility and this person as a stock with low volatility, so a high volatility stock is going to have more expensive options, just like a very unhealthy person is going to have to pay a ton of money for life insurance.
A low volatility stock will have cheap options in the same way that a very healthy person isn’t going to have to pay that much for life insurance.
This demonstrates how a stock that is expected to have high volatility will have expensive options. A stock that is expected to have low volatility will have cheap options, and this doesn’t just apply to the 37 strikes put.
You can see that the puts and calls at every strike are more expensive on the news than on fix; okay, you get it high implied volatility equals expensive options, low implied volatility equals cheap options simple enough high risk means expensive insurance, and low risk equals cheap insurance.
Now let’s talk about what this would mean for your trading.
Well, just like a stock’s price can go up or down, its implied volatility can also go up or down if implied volatility goes up, then the options, both calls, and puts, will get more expensive, and if implied volatility goes down, its options will get cheaper, but you might be wondering what the heck would cause implied volatility to go up or down.
Well, here’s the thing: the implied volatility of a stock is determined by its options prices, not the other way around.
Again, differently, the option prices are actually what tell us the future of the expected move, also known as implied the volatility of a stock is like the option prices are what they are.
Those prices spit out the implied volatility number, which tells us the stock’s expected move, so that doesn’t answer the question, and maybe your head is spinning at this point.
But let me ask you what causes a stock price to go up or down could be many things.
Still, it simply comes down to supply and demand if there are a lot of buyers, the stocks price will go up, and if there are a ton of sellers the stocks price will go down options are the same way tons of option buyers would cause the options to get more expensive.
Tons of option sellers would cause an option to get cheaper than the options prices.
It would tell us what the implied volatility is, so what would cause the implied volatility to go up or down? Well, it’s just a question of what would cause a lot of buyers for options and what would cause a lot of sellers to answer this question.
Let’s think of options as insurance again which would cause a lot of demand for insurance fear of the unknown when investors are scared and feel like they have a lot of risks, they might start buying options to protect their portfolios because they expect a lot of volatility.
All of these option buyers would, of course, cause the options prices to go up. Therefore, the implied volatility number would also go up, which makes sense right because the investors are expecting a lot of volatility so, in essence, implied volatility is like a fear gauge for the market now as a newbie.
If that doesn’t make your head spin and make you want to give up, then I don’t know what will if that didn’t make sense, don’t worry because fortunately, it doesn’t matter right now.
Just understand that if a stock’s implied volatility goes up, then that means its options are getting more expensive, and if a stock’s implied volatility goes down, then its options are getting cheaper.
This is a massive part of our trading strategy because implied volatility is very predictable, whereas stock prices aren’t that predictable, so alright, guys, that’s it.
Those are the three factors that affect an options price.
Now let’s check out some real examples to see if we can put what you’ve learned so far into practice, so again we’re looking at Twitter options, which have 28 days to expiration.
Let’s use a tool on the think or swim platform called the tool to try and estimate how an option you own might be affected by each of these three factors; you learned about how this is just for demonstration
purposes, and you don’t need to understand how to use this tool or even how to use this platform at all right now.
It’s just to help you understand what the price of these options will do in different scenarios and let’s make this a little easier to see; we’re going to set this up to only display one option strike, and alright, so we have the 19 strike option showing now let’s say we want to make a bet that Twitter stock is going to go much higher over the next 28 days.
We could do this by buying a call option, so that’s what we’re going to do.
In this example, we’re just going to say we bought one contract of this 19 strike call option, and you can see the current price of this option is around 128, so multiply that number by 100, and the actual cost of this option contract is 128 dollars.
Whether or not this trade will be profitable daily will be determined by all three factors you just learned about.
So first, we’re going to look at these factors individually. You learned that all out-of-the-money options would be worthless at the expiration date.
The stock didn’t move in the first scenario, and implied volatility didn’t change.
The only thing that happens as time passes, so the only thing we’re going to change is this date that you see here. As each day passes, this options price is decaying and gradually going to zero.
So if this scenario were to happen, you would lose the entire price you paid for the option, which was 128 dollars.
Okay, now let’s say the price of Twitter goes higher immediately after entering the trade, so no time passes and implied volatility doesn’t change, so let’s say the stock is instantly one point higher.
You can see the price of this option is at 179 now let’s say it went up another point so it’s up a total of two points from where you entered you can see that the options price is now at 238 so if you bought the option for 128 and sell it for 238 then you made 110 dollars on the trade.
Just a quick side note, you may wonder why the option went up 110 when the underlying stock went up. You’re going to learn why this is the case and how to estimate this type of thing while trading options in the option greeks article.
Okay, so there’s one more factor that affects an options price on day by day basis, and that is the daily changes in the underlying stocks implied volatility, so for this scenario, let’s say the stock doesn’t move.
No time passes either the implied volatility just magically jumps up by 25 you can see that the call options price went from 128 to 179 so you would have turned your 128 dollars into 179 dollars for a total profit of 51 dollars.
Now the reality is there will rarely ever be a time when only one of these factors changes without the other two also changing, the underlying stocks price and implied volatility will constantly be changing daily, and time is always passing, so now let’s look at a few scenarios where all three of these things are affecting the options price at once.
So in this scenario, let’s say that just one week has gone by and the stocks price has risen by a dollar and fifty cents per share; you can see that the price of this option we own is now at 184, so that means we’ve turned our 128 dollars into 184 dollars for a profit of 56. on the trade.
In this scenario, the stocks price went up quite a bit, and time decayed, well it hurt us of course you know it’s always going to hurt us if we are buying options, but it didn’t hurt us that much so we were still able to make a pretty nice profit.
Okay, now in this scenario, let’s say the stock still went up by a dollar and fifty cents per share, but this time instead of doing so in one week, it took three weeks, so we’ll move the date forward three weeks, and you can see the options price is 123.
So our total loss in this scenario is 5 dollars, so the stock went up, which helped us, of course, but it took too much time to go up, so the time decay was too much here for it to even matter that the stock went in our favor and this resulted in a slight loss on the trade.
Okay, now let’s say one week goes by, the stock goes up by 50 cents per share, and implied volatility goes down by 10 percent.
You can see that the options price is now 112 resulting in a 16 loss, so the stock went up as we wanted, and it didn’t take much time to do so.
Still, in this case, the implied volatility went down, so the drop in implied volatility plus the little bit of time decay that occurred more than canceled out that the stock price went up, which caused us to lose money.
Okay, just one more scenario this time; let’s say the stock doesn’t move, implied volatility goes up by a full 25 percent, but a little over three weeks have gone by, and there are now only four days left until expiration.
You can see that the price of this option is now 53 cents resulting in a loss of 75 dollars, so the stock didn’t move at all volatility went up huge, which is precisely what we would want to happen.
Still, time decay more than canceled out the massive spike in implied volatility which caused us to lose money on this trade.
You’ll notice that in most of these scenarios, we lost money, and in most of these scenarios, the stock
went in our favor, so you might be thinking, why am I learning how to trade options again?
Remember, in all of these scenarios, we bought this option, and we’ve repeatedly mentioned that this is our least favorite way to trade options; in fact, we don’t ever trade options in this way.
The bottom line is there are two sides to every trade, and you can take either side, so alright, guys hope you enjoyed the article.
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