Options Trading Basics
Understanding the fundamental concepts of options trading is essential for successful trading.
What Are Options?
Options are contracts that give the holder the right, but not the obligation, to buy or sell an asset at a specific price within a set time period.
Key Characteristics:
- Contract represents 100 shares of the underlying stock
- Limited time until expiration
- Strike price determines buy/sell price
- Premium is the cost of the option
Calls vs Puts
Call Options
- Right to buy stock at strike price
- Profit from stock price increases
- Limited risk when buying (premium paid)
- Unlimited risk when selling
Put Options
- Right to sell stock at strike price
- Profit from stock price decreases
- Limited risk when buying (premium paid)
- Limited risk when selling (strike price)
Strike Prices & Expiration
Strike Prices
- The strike price is the predetermined price at which you agree to buy or sell the stock
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For call options:
- Strike above current price = Out of the money (OTM)
- Strike below current price = In the money (ITM)
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For put options:
- Strike below current price = Out of the money (OTM)
- Strike above current price = In the money (ITM)
- At-the-money (ATM): When strike price equals current stock price
Expiration
- The date when your option contract expires and becomes worthless if not exercised
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Common expiration types:
- Weekly options: Expire every Friday
- LEAPS: Long-term options that expire > 1 year out
- Options expire at market close on expiration day
Options Greeks
Think of Options Greeks as your trading dashboard - they're like gauges that help you understand what's happening with your options. Delta is your most important gauge, while the others provide supporting information.
Delta (Δ) - Your Probability Guide
Delta is your best friend in options trading. Think of it as a rough estimate of your chances of making money:
- A delta of 0.50 means about a 50% chance the option will stay above/below your strike price
- For selling calls: Lower delta (0.20-0.30) means roughly 70-80% probability the stock stays below your strike
- For selling puts: Lower delta (0.20-0.30) means roughly 70-80% probability the stock stays above your strike
Real-World Example:
If you sell a put with -0.30 delta, there's roughly a 70% chance the stock stays above your strike price. This is why many traders sell puts with 0.10-0.30 delta for a good balance of risk and reward.
Theta (Θ) - Time Is Money
Think of theta as a countdown timer on a discount:
- Option buyers pay this fee (lose money each day)
- Option sellers collect this fee (make money each day)
- Like a melting ice cube - melts faster as expiration approaches
Real-World Example:
Imagine buying a concert ticket from a reseller for $200 two months before the show. As the concert date gets closer, people become less willing to pay high prices. A week before, you might only be able to sell it for $150. The day of the show, maybe only $100. This is exactly how theta works - the value drops more quickly as you get closer to expiration, and option sellers profit from this natural decline.
Gamma (Γ) - The Speed Warning
Think of gamma as your position's sensitivity to price changes:
- Low gamma = smooth, predictable changes
- High gamma = sudden, dramatic changes
- Highest when stock price is near your strike price
Real-World Example:
Think of driving on a highway. When you're far from your exit (like an option far from its strike price), you can change lanes smoothly. But when you're right next to your exit (like an option near its strike price), any small movement requires quick, dramatic steering corrections. This is gamma - it warns you when your position might need sudden adjustments due to small price changes.
Vega (V) - The Uncertainty Meter
Think of Vega as measuring how much uncertainty affects your option's price:
- Higher uncertainty = More expensive options
- More time left = More affected by uncertainty
- At-the-money options are most affected
Real-World Example:
Imagine two identical options on Apple stock, but one expires tomorrow and one expires in two months. If Apple announces earnings are coming up (creating uncertainty):
- Tomorrow's option: barely changes (not enough time for big moves)
- Two-month option: becomes much more valuable (plenty of time for big moves)
How Greeks Work Together
Think of Options Like Driving a Car
- Delta: Your GPS (tells you if you're on the right path)
- Gamma: Your speedometer (shows how fast things are changing)
- Theta: Your fuel gauge (shows how much time you have left)
- Vega: Your weather forecast (warns you about stormy conditions)
Real-World Example: Tesla Put Option
You sell a Tesla put option at $200 when the stock is at $220:
When Stock is at $220 (Far from Your $200 Strike):
- Delta: -0.30 (Good! You have a 70% chance of winning)
- Theta: Making $0.03 per share per day ($3 per contract since each contract is 100 shares)
- Gamma: 0.01 (If Tesla stock price moves up/down by $1, your delta only changes by 0.01)
- Vega: 0.05 (If market implied volatility (IV) goes up by 1%, option price increases by $0.05 per share)
When Stock Drops to $205 (Near Your $200 Strike):
- Delta: -0.45 (Warning! Odds are getting worse)
- Theta: $0.05 per share per day ($5 per contract) - Higher theta near the strike!
- Gamma: 0.04 (If Tesla stock price moves up/down by $1, your delta now changes by 0.04 - much more risky!)
- Vega: 0.05 (If implied volatility (IV) goes up by 1%, option price still increases by $0.05 per share)
What You Need to Remember
- Stay far from your strike price for smoother sailing
- Time decay (Theta) is your friend when selling options
- Watch out when price gets close to your strike!
- Avoid earnings and big news when possible
The further you are from your strike price, the less you need to worry about price changes. It's like driving - the further you are from other cars, the safer you are!
Why Delta Matters Most:
For selling options (like in the Wheel Strategy), delta helps you choose positions with a good chance of success. A 0.30 delta put means you're selling at a price where the stock has only a 30% chance of falling below - giving you a 70% chance of keeping your premium. This is why many successful traders focus primarily on delta when selecting their trades.