Background Information
All traders need to understand the terminology of their trading area. Options like all distinct trades have their own terminology which must be thoroughly understood before you start to trade. All the trade setups are explained in these terms and rationales for success are also explained in these terms, so understanding them gives you a huge advantage.
Option
An option is a contract between two parties in which the stock option buyer (holder) purchases the right (but not the obligation) to buy/sell 100 shares of an underlying stock at a predetermined price from/to the option seller (writer) within a fixed period of time.
Options Chain
The options chain shows the available call and put strike prices for a specific underlying security and expiration month.
Option Contract Specifications
The following terms are specified in an option contract.
Option Class
The two classes of stock options are puts and calls. Call options confers the buyer the right to buy the underlying stock while put options give him the rights to sell them.
Option Strike Price
The strike price is the price at which the underlying asset is to be bought or sold when the option is exercised. It's relation to the market value of the underlying asset affects the moneyness of the option and is a major determinant of the option's premium.
Option Premium/Price
In exchange for the rights conferred by the option, the option buyer have to pay the option seller a premium for carrying on the risk that comes with the obligation. The option premium depends on the strike price, volatility of the underlying, as well as the time remaining to expiration.
Option Expiration Date
Option contracts are wasting assets and all options expire after a period of time. Once the stock option expires, the right to exercise no longer exists and the stock option becomes worthless. The expiration month is specified for each option contract. The specific date on which expiration occurs depends on the type of option. For instance, stock options listed in the United States expire on the third Friday of the expiration month.
Option Style
An option contract can be either American style or European style. The manner in which options can be exercised also depends on the style of the option. American style options can be exercised any time before expiration while European style options can only be exercise on expiration date itself. All of the stock options currently traded in the marketplaces are American-style options.
Underlying Asset
The underlying asset is the security which the option seller has the obligation to deliver to or purchase from the option holder in the event the option is exercised. In the case of stock options, the underlying asset refers to the shares of a specific company. Options are also available for other types of securities such as currencies, indices and commodities.
Contract Multiplier
The contract multiplier states the quantity of the underlying asset that needs to be delivered in the event the option is exercised. For stock options, each contract covers 100 shares.
The Options Market
Participants in the options market buy and sell call and put options. Those who buy options are called holders. Sellers of options are called writers. Option holders are said to have long positions, and writers are said to have short positions.
Now let’s move on to some more exciting terminology, I hope.
Call Option
A call option is an option contract in which the holder (buyer) has the right (but not the obligation) to buy a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration). For the writer (seller) of a call option, it represents an obligation to sell the underlying security at the strike price if the option is exercised. The call option writer is paid a premium for taking on the risk associated with the obligation. For stock options, each contract covers 100 shares.
Put Option
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration). For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation. For stock options, each contract covers 100 shares.
Moneyness
Moneyness is a term describing the relationship between the strike price of an option and the current trading price of its underlying security. In options trading, terms such as in-the-money, out-of-the-money and at-the-money describe the moneyness of options.
In-the-Money (ITM)
A call option is in-the-money when its strike price is below the current trading price of the underlying asset. A put option is in-the-money when its strike price is above the current trading price of the underlying asset. In-the-money options are generally more expensive as their premiums consist of significant intrinsic value on top of their time value.
Out-of-the-Money (OTM)
Calls are out-of-the-money when their strike price is above the market price of the underlying asset. Puts are out-of-the-money when their strike price is below the market price of the underlying asset. Out-of-the-money options have zero intrinsic value. Their entire premium is composed of only time value. Out-of-the-money options are cheaper than in-the-money options as they possess greater likelihood of expiring worthless.
At-the-Money (ATM)
An at-the-money option is a call or put option that has a strike price that is equal to the market price of the underlying asset. Like OTM options, ATM options possess no intrinsic value and contain only time value which is greatly influenced by the volatility of the underlying security and the passage of time. Often, it is not easy to find an option with a strike price that is exactly equal to the market price of the underlying. Hence, close-to-the-money or near-the-money options are bought or sold instead.
Intrinsic Value
The intrinsic value is determined by the difference between the current trading price and the strike price. Only in-the-money options have intrinsic value. Intrinsic value can be computed for in-the-money options by taking the difference between the strike price and the current trading price. Out-of-the-money options have no intrinsic value.
Extrinsic or Time Value
An option's time value is dependent upon the length of time remaining to exercise the option, the moneyness of the option, as well as the volatility of the underlying security's market price. The time value of an option decreases as its expiration date approaches and becomes worthless after that date. This phenomenon is known as time decay. As such, options are also wasting assets. For in-the-money options, time value can be calculated by subtracting the intrinsic value from the option price. Time value decreases as the option goes deeper into the money. For out-of-the-money options, since there is zero intrinsic value, time value = option price. Typically, higher volatility give rise to higher time value. In general, time value increases as the uncertainty of the option's value at expiry increases.
Delta
Delta is the change in the options price compared to the change in the price of the underlying asset.
The option's delta is the rate of change of the price of the option with respect to its underlying security's price. The delta of an option ranges in value from 0 to 1 for calls (0 to -1 for puts) and reflects the increase or decrease in the price of the option in response to a 1 point movement of the underlying asset price. Far out-of-the-money options have delta values close to 0 while deep in-the-money options have deltas that are close to 1. As the time remaining to expiration grows shorter, the extrinsic or time value of the option evaporates and correspondingly, the delta of in-the-money options increases while the delta of out-of-the-money options decreases.
Theta
Theta is the change in the price of the option or more specifically rate of erosion of the options price over time.
This results in option's theta being called a measurement of the option's time decay. The theta measures the rate at which options lose their value, specifically the time value, as the expiration date draws nearer. Generally expressed as a negative number, the theta of an option reflects the amount by which the option's value will decrease every day. An option’s value is divided into extrinsic and intrinsic value and extrinsic value is all time. This theta causes OTM options to lose value rapidly down to zero due to the lack of intrinsic value. Conversely ITM options lose less of their total value over time due to their higher intrinsic value.
Vega
Vega is the amount call and put prices will change for every 1% change in implied volatility. Vega does not have any effect on the intrinsic value of options and only affects the “time value” of an option’s price. That said, IV is the most critical element of an option the option pricing model because it’s the only unknown.
I think that’s a good list to start with and If you think of something I missed a beginner needs to know, please add it in the comments below.
Option Spread Trading
A very popular type of trade amongst option traders who are into math is the spread. The is a two transaction trade, where the first part involves selling an option to buy a stock at a certain price in the future. The seller is betting the asset will never reach that price and surely never surpass it. The second part of the spread is a purchase of an option to buy the stock at a price 1 dollar or more above the stock price named in the of the option you just sold, just in case the stock reaches or surpasses the price of the one you sold, you won’t have to go into the market and buy the asset at a much higher price then you agreed to sell it for, thus guaranteeing a loss, instead you could still profit or at least break even.
Example:
Apple’s market price is $100.00
You sell an option at the 80th percentile $110 strike, it’s $6.00/share, 100 shares, $600
You buy an option at the 85th percentile $115 strike, it’s $5.00/share, 100 shares, $500
Your risk is the five dollar difference between the two prices $110 and $115, times 100 or $500 minus the sum of ; the premium you got for the option you sold, in this example $600, minus the premium you paid for the option you bought, in this case $500, or total potential profit or net premium of $100.0. Thus you risk $500 for $100. Your chance of success here at the 80th percentile is 80%. Your chance of failure 20%. At this point it’s good to discus probability of success in more detail, both low probability and high probability trading have their proponents.
Low Probability Trading
Next, I wish to discus low probability options trading and why would anyone do it?
The first type of options trading new traders learn is buying and selling options. It is easy to understand as you buy low and sell high. It’s a single transaction trade and it’s very popular. The irony of buying options as a strategy, is that technically it’s a LOW probability play. That’s right, in the land of percentiles and probabilities, this low probability play is very popular. That’s what I will discus in this post.
Source
As eluded to above, buying options is profitable when the underlying stock or asset increases in value. This is a straight forward buy low, sell high transaction. Additionally, the options market allows the trader many advantages over the stock market. First there is the multiplier effect of buying contracts, which represent control over one hundred stock shares. Second you invest a much smaller amount of money to buy the options contract, which allow you to control one hundred shares of stock versus buying 100 shares of the same stock. For example 100 shares of Apple is $10,000.00 versus one call option contract for $300.00. Third a small change in the price of the stock causes a much greater change in the price of the option. For example a five dollar change in Apple’s stock price is a 4% change of $5 in a $100 dollar stock, but that same price change $5.00 of a $10.00 Option is a 50% change. This type of leverage and high rate of return on small, short term changes in the stock price is both intoxicating and addictive. Some traders study cyclical stocks, to buy on the dips and sell on the recovery phase or others buy options ahead of stock splints or favorable earnings announcements. These strategies are meant to make up for the statistical disadvantages inherent to buying stock options, and using them as an investment vehicle.
What are those statistical disadvantages?
They are the opposite of the statistical advantages of selling options. So for example, in terms of probabilities if you pick as a strike price the current market value of the stock there’s a 50% chance it will close at that price when the option expires. This is the statistically calculated probability, backed by a Nobel Prize for Math and Economics. Now as you move away from the market price you are following a bell shaped curve of probabilities. The higher the price or the lower the price, the less likely it becomes that the stock will be at that price on Option expiration date. Each stock has a slightly different bell shaped curve, in that the one standard deviation move could be one dollar for stock A, but that same one standard deviation move could be ten dollars for stock B. So you should review the price probability curve for each stock before trading. The option buyer wants to buy low and sell high. The majority of Option buys occur far from the market price. This is where the probability of success maybe 20% or less, that’s 1 chance in five, but in the options market the rate of return mirrors the odds of success, so that 1 in 5 shot of success pays 5 to 1 on your investment, in general.
For example, if Apple’s market price is $100.00, and the strike price of $110.00 is at the 80th percentile, your cost or the initial purchase price called the premium out at the 80th percentile on the bell shaped probability curve may be $1.00 (expiration date in 30 days). However at the 80th percentile on the curve, the probability of the stock price reaching the corresponding strike price is the inverse of the probability of 80% or only 20%. Those are not good odds, but your reward for taking that bet with 1:5 odds is a 5:1 return, you option price would rise to around $6.00 if the stock rose ten dollars in 30 days. So options math says this is a low probability options trade and it is ill advised. It is often said, that if an Options trader can suppress the two emotions fear and greed they can get rich. But the low cost and potential high reward is attractive, so traders buy similar options all the time. It is from this statistical disadvantage that options trading gets its reputation for being a gamble and sometimes is referred to as purely gambling.
High probability trading
The seller of an option is hoping the underlying stock’s price never hits the strike price and the buyer of the option is hoping the stock reaches and surpasses the strike price.
The option premium for any strike price is calculated based on the probability of the stock reaching that price, which in turn defines the risk of the buyer and the seller, and the amount of risk determines the price.
So for example, in terms of probabilities if you pick as a strike price the current market value of the stock there’s a 50% chance it will close at that price when the option expires. That may come as a surprise, but statistically speaking when you look at short term of 30-60 days, that’s the calculated probability, backed by Nobel Prize for Economics math formulas. Now as you move away from the market price you are following a bell shaped curve of probabilities. The higher the price or the lower the price, the less likely it becomes that the stock will be at that price on Option expiration date. Each stick has different bell shaped curves in that the one standard deviation move could be one dollar for stock A but ten dollars for stock B. So you should review the price probability curve for each stock before trading.
Now when we say high probability or low probability trading we refer to the probability of a successful trade, defined as profiting one penny. In high probability trading you are trading in the 80% or greater probability zone, which corresponds to an 80% chance of successful trade. Those are the words, let’s look at an example.
Example of high probability trade
You wish to sell calls on Apple.
Apple market price is $100.
Apple call options with a strike price of $105 and an expiration December 14th are in the 55% and have a premium of $7.00.
Apple call options with a strike price of $110 and an expiration December 14th are in the 85% and have a premium of $1.00.
You decide to go with a high probability trade at $110 Strike price and sell one contract for 1$ per share or $100 total.
You could have sold the $115 Strike price at the 95th percentile, but the premium was 35 cents.
Now you have sold someone the right to buy 100 shares of Apple from you at $110.
If they exercise their option you must go into the market and buy Apple for market price and sell for your strike price.
That strike for Apple, this month and with that expiration was 85th percentile.
That means there’s a 85% probability that Apple won’t reach that price by the Options expiration date and a 15% probability that it will.
The high probability it won’t reach that price means your premium is smaller then a 75% Strike price, but your risk is also smaller. You have a 85% probability of success and a 15% probability of failure. You are the seller, so for you this is a high probability trade. You could make more money selling strike prices closer to the Apple current market price, but each step closer increases the probability of the stock closing at that price and decreases your probability of success.
This is called a high probability trade, because the mathematical probabilities are high at 85% on your side. Some people only trade high probabilities because they have such a good chance of winning.
Closing Thoughts
I believe that those who invest in anything; real estate, gold, stocks or cryptocurrency understand that all investing is a gamble or politely referred to as calculated risks. Meaning we thought about the pros and the cons and then invested. The two emotions fear and greed can lead to your ruin, despite the vehicle.
✍🏼 Written by Shortsegments