Options Basics: 101

One of the core pillars of the barbell strategy is to make more money with a smaller percentage of our portfolio than others. This way we risk less and earn a similar rate of return.

Options Basics

One of the core pillars of the barbell strategy is to make more money with a smaller percentage of our portfolio than others. This way we risk less and earn a similar rate of return.

A major amplifier of gains is using options. Be employing options strategies we can easily make 15% - 20% a year on our portfolios… Conservatively. But that’s not our goal. Our goal is to do better than that. And learning the proper strategies and when to implement said strategies, we can do better.

While we will focus more on advanced strategies here, I want to lay the foundation of options strategies for anyone looking to pick up options trading. While this is a starting point, I’m sure there are more comprehensive options trading courses out there on the internet.

And options come with extreme risk. It is easily possible to lose 100% of your money with options. But it’s also possible to lose MORE THAN 100% of your investment if you structure a trade wrong.

So please, please, please fully understand options before starting to trade these securities.

An option is a derivative of another financial product

Here we’re talking about options on equities. It is possible to get options on futures, interest rates, fx, cryptocurrencies, etc… but for our purposes, we’re talking about options on stocks.

Each option contract controls 100 shares of a stock. And because of this fact, to get the dollar amount of an option contract, investors must multiply the listed price by 100. If an option has a listed price of $5.25, it will cost us $525 to buy each contract.

A buyer of a contract is said to the be the holder and they are long the contract.

A seller is said to be the writer of the contract and they are short the contract.

There are two kinds of options contracts.

1.       Call options give buyers the right, but not the obligation, to purchase 100 shares at a specified price for a period of time.

2.       Put options give buys the right, but not the obligation, to sell 100 shares at a specified price for a period of time.

Now it’s important to know a few terms associated with each contract.

Expiration Date – this is the date the option contract is good for. If an option expires on December 15, 2022, the holder has until then to sell the option for cash or exercise the option.

Exercise – this is the term if the holder of the options wants to execute the contract. A call buyer would exercise the contract to take ownership of 100 shares. A put buyer would exercise the contract to sell 100 shares of the underlying stock.

Strike Price – the price at which the stock trades hands. If a call buyer has a $50 strike call, they can exercise the contract and buy shares of the underlying for $50… Even if shares are $150 or more.

A put buyer with a $50 strike put can sell shares for $50… Even if the company went bankrupt and its shares are worthless. This is why I like to say buying a put option is like taking out an insurance policy on your stocks.

Assignment – This is the term for when the seller of an option is notified of the buyer’s intention to exercise. Sellers of options must supply the underlying to the holder even if they don’t want to. Selling options comes with a lot of risk. Do NOT sell options without fully understanding the potential outcomes.

Important Options Lingo for Investors

At The Money – a term for the strike price that is nearest the price of the underlying stock. If Apple were trading at $150 a share, the options with a $150 strike would be at the money.

In The Money – those options that would have a value if they were exercised. A call option that is in the money has a strike prices below the price of the stock. A put option with a strike price higher than $150 is in the money.

With Apple at $150, a call with a $145 strike would be worth $5 to a holder at expiration since it allows the holder to purchase shares $5 cheaper than the market. A put with a $155 strike would be worth $5 to the holder at expiration since it allows them to sell shares for $5 more than the market.

Out of the Money – options that would be worthless if they were exercised. Sticking with Apple again, a holder of the $155 strike call option would be worthless since he isn’t going to willingly pay $5 more than $150 market price.

A put with a $145 strike price is also worthless since someone won’t want to exercise the option to sell shares for $5 under the market price.

Intrinsic Value – the value of the option due to it being in the money. If we were to buy a $145 strike Apple call that expires in one month we’d like pay around $8 for the privilege. With shares at $150, the hypothetical options contract would have $5 of intrinsic value. The other $3 dollars is called…

Extrinsic Value – this is the value of the contract above and beyond the intrinsic value.

Premium – the value we pay for the options. So in the above example with Apple trading at $150 a share, the premium for the one month out $145 strike Apple call is $8. This is made up of $5 of intrinsic value and $3 of extrinsic value.

Time Decay – The amount of extrinsic value. Time decay is typically expressed in daily terms. So our options contract as $3 of extrinsic value over the following month. If the option decayed linearly (which it does not) over its 30 day life, the option would have 10 cents of time decay a day ($3.00 / 30 days).

Implied Volatility – the expected price movement, in annual terms, expected by traders based upon the prices paid for the options. The more volatile the stock, the more traders must pay to purchase the call. Volatility is one of the most important concepts of options trading. And one we’ll talk about much more as the series goes on.

Long Dated – These are options that have an expiration relatively longer than another option. A long dated option may have an expiration date 6 months or 2 years from now. There is no set definition, just that it expires in a long time from now.

LEAPs – These are options that have an expiration date longer than 1 year from now.

These are the main words traders mention about when discussing options. Eventually you’ll memorize all these keywords. But for now just bookmark this page and come back to it if you hear a term you’re not aware of.

Next we’re going to move onto the next set of keywords all options investors must know… And truly understand.

The Greeks

When leaning options, you’ll inevitably come across people talking about “The Greeks.” This is not some kind of European criminal organization. These are five fundamental factors that impact the pricing of options. Specifically, how the prices change over time and with price swings.

Not all options pricing is intuitive. And it can be really complex. Most good options platforms will help us with these pricing inputs. But we have to know how to read the data.

These five Greeks are important to know inside and out. Not only for buying just one call or one put. But also for utilizing multi-leg strategies.

Each of these Greeks has its own quirks, but these quirks go beyond the scope of this intro article.

The first Greek is…

Delta – this is the change in the options price for every $1 change in the underlying stock. For the calculus geeks out there, this is the first derivative.

The delta will always be between -1 and 1. Calls will have a positive delta. Puts will have a negative delta (the value of a put goes down when the stock goes up).

Let’s go back to the Apple example. Apple stock is trading at $150. And we bought a slightly in the money call with a $145 strike for $8. In this case the delta is likely 0.55 – meaning that if Apple stock goes up $1, we can expect our option to increase in value by 55 cents.

Gamma – this is the change in the delta for every $1 change in the underlying stock. It’s the delta of the delta, also known as the second derivative of the security. So in our Apple example, the gamma is likely 0.02. That means for every dollar higher Apple goes, the delta will increase 0.02. So if Apple goes $151 the new delta will be 0.57… Meaning the option will increase 57 cents when Apple goes from $151 to $152.

For long-dated options, the gamma will remain fairly constant. But as options that are near the money approach expiration, the gamma can get very high… And can cause the option prices to fluctuate wildly.

Vega – the dollar change in the price of an option per a one-tick increase in implied volatility. This is important to know because an option that is more volatile will have a higher value than a less volatile one (all else equal).

So if the vega of Apple is 0.10 and the implied volatility goes from from 25 to 26, we can expect the price of the contract to increase by $0.10. A 8 tick move in implied volatility will increase the price of the option by $0.80.

Theta – the dollar change in the price of an option as it gets one day closer to expiration. This is also known as time decay.

Almost all options have extrinsic value. Options that are longer dated have more extrinsic value, but they decay at a slower rate. Time decay speeds up exponentially as the option gets closer to expirations.

So if the price of our Apple shares stay the same for one day and the theta for the stock is -.05 it means the option will lose 5 cents of its value that day. So after the day the value of the options contract we bought for $8 will decline to $7.95.

Rho – the dollar change of an option due to a one percentage point change in the interest rate. All investments have what’s called an “opportunity cost.” That’s what you could have invested in. And options investors could have bought some short-term Treasuries instead. So the higher the interest rate, the less the option is worth.

But with low interest rates many have forgotten about this Greek. It’s not as important as it was. But that may change if interest rates continue rising… Rho also has a larger impact on longer dated options because of the cost of carry.

These are the Main Terms

Here are the main terms. I’m sure we’ll add more terms to this section as the site progresses. It will be a living document. But for now, we’ll stick to the basics. If you’re just starting your journey of learning options, bookmark this page and come back until you have internalized the meanings and implications of these terms.