What are Options?
An option is defined as the right, not the obligation, to buy (or sell) an asset at a fixed
price before a predetermined date.
Let's have a look at that definition and see if we can pick out the component parts:
The right, not the obligation
To buy or sell an asset
At a fixed price
Before a predetermined date
These component parts have important consequences on the valuation of an option.
Remember that the option itself has a value which we will look at after we finish with the
definitions.
Before we go ahead and look at the ways in which options are valued, let's consider the
words "right not the obligation":
The Right, not the Obligation
Buying gives you the Right
Buying an option (call or put) conveys the right, not the obligation to buy (call) or
sell (put) an underlying instrument (eg a share).
When you buy an option you are NOT obligated to buy or sell the underlying
instrument - you simply have the right to do so at the fixed (Exercise or Strike)
price.
Your risk, when you buy an option, is simply the price you paid for it.
Selling (naked) imposes the Obligation
Selling an option (call or put) obliges you to buy (put) from or deliver (call) to the
option buyer.
Selling options naked (ie when you have not bought a position in the underlying
instrument or an option to hedge against it) will give you an unlimited risk profile.
Combined with the fact that you are obliged to do something, this is generally not a
preferable position to put yourself in.
Now let's consider the words "to buy or sell an asset":
Types of Option - Calls and Puts
Memory Tip
Call is to Buy - think of calling up a friend - a call is the option to buy, you think the
market is going up
The real reason it is named a call is because when you buy a call you can "call" the
underlying asset away from the person who sold it to you.
Put is to Sell - think of a "put down" - a put is the option to sell, you think the market is
going down
The real reason it is named a put is because when you buy a put you can "put" the
underlying asset to the person who sold it to you.
1
A CALL is an option to BUY
A PUT is an option to SELL
Therefore:
A CALL option is the right, not the obligation to BUY an asset at a fixed price
before a predetermined date
A PUT option is the right, not the obligation to SELL an asset at a fixed price
before a predetermined date
Types of Calls and Puts
Options can be either American Style or European Style.
American Style options allow the option buyer to exercise the option at any time
before the expiration date
European Style options do NOT allow the option buyer to exercise the option
before the expiration date.
Most traded options are American Style and all US Equity options are American Style.
American Style options are slightly more valuable than European Style options because of
their added flexibility.
Now we need to look at the words "at a fixed price":
Exercise (or Strike) Price
The Exercise (or Strike) Price is the fixed price at which the option can be exercised.
So if you buy a call option which has a strike price of $50, then you have bought yourself the
option to buy the asset at a price of $50.
However, in the real world you only want to exercise your right to buy that asset at $50 if the
underlying asset is actually worth more than $50 in the market. If the underlying asset is
below $50, there is no point in doing so because you'd be exercising your right to buy the
asset for $50, when it's only actually worth, say, $40. No-one would do that because they
could buy it for $40 in the market.
This leads us to the words "before a predetermined date"
2
Expiration Date
This is the date before which the option can be exercised.
At expiration, the call option is only worth the price of the asset less the strike price.
At expiration the put option is only worth the strike price less the price of the asset.
(For US Equity Options the Expiration Dates fall on the 3rd Friday of every month)
Summary of Options Definition
Stocks
Options
Stocks consist of individual shares which
are units of ownership in a corporation or
organization.
Options are derivative instruments. In other
words their value is derived from the
underlying stock (or underlying asset).
Options have expiration dates. This means that
Individual shares go on in perpetuity
options are wasting assets in that the passage of
(unless the corporation goes bust or is
time will erode that portion of the option's value
taken over). They do not "expire" as such.
as the expiration date looms.
Stockholders are the owners of the
company and have voting rights.
Stockholders are also entitled to dividend
payments as and when they are paid.
Options convey no rights of ownership of the
underlying asset. They merely convey the right
to buy or sell the underlying asset.
Why Options?
You can trade options in order to accomplish a variety of investment objectives. Here are
a few examples of how options can be useful coupled with examples of associated
strategies:
Rationale
Example of a Strategy
Insurance against existing positions
Synthetic Call
Collar
Income enhancement
Covered Call
Naked Put
Profit from declining stocks
Profit from volatile stocks
Long Put
Straddle
Strangle
Profit from range-bound stocks
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Rationale
Example of a Strategy
Butterfly
Condor
Invest in stocks by paying less out of your trading account
Synthetic Future
LEAPs
You can also use options to apply longer-term strategies of up to 3 years for US stocks.
LEAPs are Long Term Equity Anticipation Securities. In other words they are simply
options with a longer time to expiration.
LEAPs have expiration dates of up to 3 years away (from when they are first listed) and are
available for over 300 individual stocks and a number of indices in the US.
Risk Profile Charts
In order to learn about options with maximum speed it's best to transform words and
concepts into pictures.
Do you know what buying an asset like a stock or a future looks like? In order to find out,
we need to learn how to draw a Risk Profile Chart. This is the cornerstone on which we
build far more complex strategies, so it's important to understand this.
Unlike a standard price chart were the x axis represents time and the y axis represents
price, a risk profile chart is structured as follows:
Example - Consider buying a stock for $25.00:
1. The X-axis represents the stock price, with the price rising as the line moves right.
2. The Y-axis represents your profit/loss for the trade.
3. The 45�� diagonal line is your risk profile for the trade. As the price of the stock
rises, so does your profit. So when the asset price rises to $50, you make $25 profit.
Current Price - Buy Price = Profit (loss)
$50.00
- $25.00 =
+$25
$10.00
- $25.00 =
($15)
4
Long Stock Risk Profile Chart
Steps to creating a Risk Profile Chart
Step 1: Y axis for profit / loss position
Step 2: X axis for underlying asset price range
5
Step 3: Breakeven line
Step 4: Risk Profile line
Short Stock Risk Profile
Now you can see what buying a stock looks like, let's look at what "shorting" a stock looks
like.
Shorting just means selling something that you don't already own. Shorting is an accepted
concept in some stock markets such as the US, but is not currently allowed in some other
stock markets such as the UK.
Remember that when you short you can lose an unlimited amount as the asset price rises,
and your maximum profit is the shorted price, here, let's say $25.00. In order to make
maximum profit from a short stock position, the asset would have to fall to zero.
6
Short Stock Risk Profile
So, now you know how to draw the most basic risk charts, we can move to options risk
profiles...
Option Risk Profiles
The importance of a risk profile chart becomes clearer when we look at options strategies.
Consider a call option:
A call option is the right, not the obligation, to buy an asset (eg a share) at a fixed price
before a predetermined date.
Let's say we want to buy a call option to buy a stock at $25.00 (strike price) before
December (expiration date) and we pay $3.50 (premium) for this option.
Call Option Risk Profile
Put Option Risk Profile
A put option is the right, not the obligation, to sell an asset (eg a share) at a fixed price
before a predetermined date.
Let's say we want to buy a put option to sell a stock at $25.00 (strike price) before
December (expiration date) and we pay $3.50 (premium) for this option.
7
Put Option Risk Profile
4 Risk Profiles
Long Call
Buying a Call
1. belief that stock will rise (bullish outlook)
2. risk limited to premium paid
3. unlimited maximum reward
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Short Call
Writing a Call
1.
2.
3.
4.
belief that stock will fall (bearish outlook)
maximum reward limited to premium received
risk potentially unlimited (as stock price rises)
can be combined with another position to limit the risk
Long Put
Buying a Put
1. belief that stock will fall (bearish outlook)
2. risk limited to premium paid
3. unlimited maximum reward up to the strike price less the premium paid
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Short Put
Writing a Put
1.
2.
3.
4.
belief that stock will rise (bullish outlook)
risk unlimited down to the Strike Price less the premium received
maximum reward limited to the premium received
can be combined with another position to limit the risk
Long Call Risk Profile
We already know that a call option is the right to buy an asset. Logically, this suggests
that the call option risk profile direction will be similar to that of buying the asset itself.
So let's have a look at an example:
Stock Price
$56.00
Call Premium
$7.33
Exercise Price
$50.00
Time to Expiration 2 months
Remember that:
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Buying gives you the Right
Buying a call option gives you the right, not the obligation to buy an underlying
instrument (eg a share).
When you buy a call option you are not obligated to buy the underlying instrument you simply have the right to do so at the Strike Price.
Your maximum risk, when you buy an option, is simply the price you paid for it.
Your maximum reward is uncapped.
Short Call Risk Profile
For every call that you buy, there is someone else on the other side of the trade. The seller
of an option is called an option writer. Logic and common sense tell us that the option
seller's risk profile must be different to that of the option buyer.
Stock Price
$56.00
Call Premium
$7.33
Exercise Price
$50.00
Time to Expiration 2 months
Remember that we already discussed the implications of selling an option - here's a
reminder:
Selling (naked) imposes the Obligation
Selling a call obliges you to deliver the underlying asset to the option buyer.
Selling options naked (ie when you have not bought a position in the underlying
instrument or an option to hedge against it) will give you an unlimited risk profile.
The continuous downward diagonal line is generally a bad sign because it means
unlimited potential risk.
Combined with the fact that you are obliged to do something, this is not an ideal
strategy for the inexperienced, however it can be combined with other positions to
create a new strategy.
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Long Put Risk Profile
So, now you know what long and short calls look like, let's look at the risk profile of a put
option.
We already know that a put option is the right to sell an asset. Logically, this suggests that
the put option risk profile direction will be the opposite to that of calls or buying the asset
itself. So, again, let's have a look at an example:
Stock Price
$77.00
Put Premium
$5.58
Exercise Price
$80.00
Time to Expiration 4 months
Remember that:
Buying gives you the Right
Buying a put gives you the right, not the obligation to sell an underlying instrument
(eg a share).
When you buy a put you are not obligated to sell the underlying instrument - you
simply have the right to do so at the Strike Price.
Your maximum risk, when you buy an option, is simply the price you paid for it.
Your maximum reward is uncapped. With long puts your reward is uncapped to the
downside, ie the strike price less the put premium. In this example that is: $80.00 $5.58 = $74.42.
For every put that you buy, there is someone else on the other side of the trade. The seller
of a put option is will have a different risk profile to that of the put option buyer.
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Short Put Risk Profile
Stock Price
$77.00
Put Premium
$5.58
Exercise Price
$80.00
Time to Expiration 4 months
Remember that we already discussed the implications of selling an option - here's another
reminder for puts:
Selling (naked) imposes the Obligation
Selling a put obliges you to buy the underlying asset to the option buyer.
Remember, when you sell a put, you have sold the right to sell to the person who
bought that put.
Selling options naked (ie when you have not bought a position in the underlying
instrument or an option to hedge against it) will give you an unlimited risk profile.
The continuous downward diagonal line is generally a bad sign because it means
uncapped risk.
Combined with the fact that you are obliged to do something, this is not an ideal
strategy for the inexperienced.
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Risk Profiles Summary
You have now learned what the essential risk profiles look like and what they mean to you
in terms of maximum risk and reward.
Profile Description Max Risk
Buy Asset purchase price
Sell Asset uncapped
Buy Call
call premium
Sell Call
uncapped
Buy Put
put premium
Sell Put
strike price less put
premium received
Max Reward
Breakeven
uncapped
short sale price
purchase price
short sale price
strike price plus call
premium paid
strike price plus call
call premium received
premium received
uncapped
strike price less put
premium paid
strike price less put
premium paid
strike price less put
put premium received
premium received
ITM, OTM and At the Money (ATM) Calls
ITM where the current stock price is above the call strike price
ATM where the current stock price is equal to or near to the call strike price
OTM where the current stock price is below the call strike price
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ITM, OTM and ATM Puts
ITM where the current stock price is below the put strike price
ATM where the current stock price is equal to or near to the put strike price
OTM where the current stock price is above the put strike price
Intrinsic and Time Value for Calls - Example 1: ITM
Call Intrinsic Value
Stock Price
Call Premium
Exercise Price
Time to Expiration
$56.00
$7.33
$50.00
2 months
Call Time Value
Stock Price
Call Premium
Exercise Price
Time to Expiration
Intrinsic Value $56.00 - $50.00 = $6.00
Time Value
Notice how [Intrinsic Value + Time Value] = the Option Value
$56.00
$7.33
$50.00
2 months
$7.33 - $6.00 = $1.33
Formulae for Intrinsic and Time Values for Calls:
Call Intrinsic Value = Stock Price - Exercise Price
Call Time Value = Call Premium - Call Intrinsic Value
The minimum Intrinsic Value is zero.
Intrinsic and Time Value for Calls - Example 2: OTM
Call Intrinsic Value
Stock Price
Call Premium
Exercise Price
Time to Expiration
Intrinsic Value
$48.00
$0.75
$50.00
2 months
$48.00 - $50.00 = $0.00
Call Time Value
Stock Price
Call Premium
Exercise Price
Time to Expiration
Time Value
$48.00
$0.75
$50.00
2 months
$0.75 - $0.00 = $0.75
Notice how [Intrinsic Value + Time Value] = the Option Value
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Formulae for Intrinsic and Time Values for Calls:
Call Intrinsic Value = Stock Price - Exercise Price
Call Time Value = Call Premium - Call Intrinsic Value
The minimum Intrinsic Value is zero.
Intrinsic and Time Value for Puts - Example 3: ITM
Put Intrinsic Value
Stock Price
Put Premium
Exercise Price
Time to Expiration
$77.00
$5.58
$80.00
4 months
Put Time Value
Stock Price
Put Premium
Exercise Price
Time to Expiration
Intrinsic Value $80.00 - $77.00 = $3.00
Time Value
Notice how [Intrinsic Value + Time Value] = the Option Value
Formulae for Intrinsic and Time Values for Puts:
$77.00
$5.58
$80.00
4 months
$5.58 - $3.00 = $2.58
Put Intrinsic Value = Exercise Price - Stock Price
Put Time Value = Put Premium - Put Intrinsic Value
The minimum Intrinsic Value is zero.
Intrinsic and Time Value for Puts - Example 4: OTM
Put Intrinsic Value
Stock Price
Put Premium
Exercise Price
Time to Expiration
Intrinsic Value
$85.00
$1.67
$80.00
4 months
$80 - $85.00 = $0.00
Put Time Value
Stock Price
Put Premium
Exercise Price
Time to Expiration
Time Value
$85.00
$1.67
$80.00
4 months
$1.67 - $0.00 = $1.67
Notice how [Intrinsic Value + Time Value] = the Option Value
Formulae for Intrinsic and Time Values for Puts:
Put Intrinsic Value = Exercise Price - Stock Price
Put Time Value = Put Premium - Put Intrinsic Value
The minimum Intrinsic Value is zero.
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The 7 Factors affecting the Pricing of Options Premiums
1.
2.
3.
4.
5.
6.
7.
Type of option (call or put)
The current Price of the underlying asset
The Exercise (Strike) Price
Time remaining to Expiration
Volatility of the underlying asset
The Dividend payable on the underlying asset
Current Interest Rates (the risk free 90 day T-Bill rate)
Put / Call Parity Explained
Call prices, Put prices and the associated asset prices are all related to each other. This
must be the case or else professional traders would be able to arbitrage (make risk free
trades).
Put-call parity is a fundamental relationship that must exist between the prices of a put
option and call option if both have the same underlying asset, Strike Price and Expiration
Date.
The Put-call parity model is based on expiration date investment values associated with 4
different securities:
1.
2.
3.
4.
A call option;
A put option with identical terms;
The underlying asset for the above call and put;
A risk-free security with the same maturity date as the options' Expiration Date and
with an expiration payoff equal to the options' Strike Price.
Put-call parity is used for 2 purposes:
1. To value a call option relative to a put with identical terms.
2. To show how the Expiration Date payoffs on any one of these 4 securities can be
replicated by taking appropriate positions in the other 3 securities (ie creating
synthetic positions).
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Contracts
Options are traded in contracts, not as individual derivative units. Each contract
represents a certain number units of the underlying asset. This number is different
for different types of asset worldwide.
Therefore, when you see a US Equity call option price of, say, $1.45, you will have
to pay $1.45 * 100 for just 1 contract. 1 contract is the minimum amount you can
trade and for US Equity Options 1 contract represents 100 individual shares.
The following table outlines the amount of underlying securities that represent 1 contract
for a few different markets where options are traded on an exchange:
Underlying Asset Units per Options Contract
US Equities
100 shares
S&P Futures
250 units
UK Equities
1,000 shares
Therefore, when you trade a Covered Call you are only "covered" if you are trading the
same number of units on each leg of the trade.
For Example:
If you are wanting to sell 3 contracts of MSFT $80 strike calls at $3.50, you will receive a
premium (before commissions) of $1,050. But you will need to buy 300 MSFT shares in
order to be "covered". This will be at a cost of 300 * the MSFT share price.
Margin
Margin is the mechanism by which you can borrow funds from your broker account
but you are required to cover your potential risk liability with liquid assets in your
account. This is particularly relevant to those traders who sell short, sell naked or
trade net credit spreads.
When you sell short, sell naked or trade a net credit spread, whilst money is
deposited into your account, there is still (in most cases) a contingent liability risk
which must be covered by sufficient funds in your account.
These funds can either be represented in cash or "marginable securities". A
marginable security is defined as an asset which is deemed by the brokerage to be
secure enough to stand as collateral against your risk on the trade. A stock like
MSFT may well be considered as a marginable security, whilst low priced stocks
(under $10) with little trading history, low trading volumes, poor liquidity and high
volatility may not be considered as acceptable collateral.
Remember that in many cases of selling short and selling naked, your potential risk
liability may be unlimited (or at least substantial). Using the Strategy Analyzers to
determine your risk profile will help you to identify those situations where your risk
potential is unacceptably high, depending on your own personal appetite for risk.
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Placing your Order
Trades can be placed either online of offline, depending on your broker account.
Use the Strategy Guides to assist you in placing your spread orders over the
telephone quickly, efficiently and accurately. By knowing what to say and how to
say it clearly, concisely and correctly you will help save both your time, the broker's
time and ensure that there are no misunderstandings.
Make sure you fill in the right figures and have them in writing before picking up
the phone to place your order. Then simply read out the order to the broker with
your limit order prices.
Because options prices are not always "clean", it is preferable to place a Limit
Order, particularly on spreads. This will ensure that you will be filled at your
specified price or not at all. By using the Limit Order function you can overwrite
the market prices in order to base your calculations on your preferred limit order on
any strategy and then see the results of your limit order risk profile.
Trading Tips
The most important things you need to know about any trade you ever do are:
Your maximum risk on the trade
Your maximum reward on the trade
Your breakeven point(s)
The Strategy Analyzers give you these crucial figures in both nominal and actual formats
for over 60 different strategies.
In addition, you also should know in advance:
The maximum loss you will accept and when to get out of a loss making trade
When to take your profits
These are crucial money management criteria, which you must determine in your own
mind before you start trading. There are wide parameters concerning money management
techniques and much depends on your own appetite and respect for risk. Just keep in mind
that it is generally a good thing to cut your losses short and to let your profits run.
Expiration
Figures courtesy of CBOE (www.cboe.com)
Many people believe that 90% of options expire worthless (ie no Intrinsic Value at
expiration). Figures from the CBOE indicate that in fact only 30% of actively
options expire worthless in each monthly cycle.
Only 10% of options are exercised during each monthly cycle. Usually this
happens in the final week before the expiration date. (CBOE)
Over 60% of all options positions are closed out in the market before expiration. In
other words option buyers sell to close their positions and option writers (sellers)
buy back to close their positions. (CBOE)
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Exercise and Assignment
Exercising Calls Means you buy the underlying stock at the Strike Price
Exercising Puts Means you sell the underlying stock at the Strike Price
The process for exercising your options is as follows:
1. notify your broker
2. your broker notifies the Options Clearing Corporation (OCC)
3. the OCC randomly chooses a brokerage firm with the appropriate short options in
the same class and series
4. the brokerage firm randomly calls one of its customers with the relevant short
options position and delivers an Assignment Notice informing them that the option
owner has exercised their right to buy (call) or sell (put)
5. the stock transaction is processed
Understanding Option Symbols
Option Symbols
Options have ticker symbols just like stocks do. The symbol accurately identifies the
underlying, the expiration month, the strike price, and the type of option.
A series of letters identify the option. They appear in the order of Root, Expiration month,
and Strike price. The letter that is used for expiration month is also used to identify
whether the option is a call or a put.
The first letter or group of letters (up to 3) identify the underlying and is called the root. It
is not the same as the stock symbol, although it can be. Microsoft has the stock symbol of
MSFT. But since that's more than 3 letters, a root symbol is devised by the standardizing
authority and a group of 3 letters is used. MSQ is the primary root for Microsoft. There
can be others under certain conditions, but for now let's keep it simple. The root for
Microsoft is MSQ.
The next to the last letter in an option symbol indicates the expiration month. If the option
is a call then the first half of the alphabet is used. If the option is a put then the last half of
the alphabet is used. The table below illustrates the codes.
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Expiration Month Codes
Calls
Puts
Jan Feb
A
B
M N
Mar
C
O
Apr
D
P
May
E
Q
Jun Jul Aug
F
G H
R
S T
Sep
I
U
Oct Nov
J
K
V
W
Dec
L
X
The last letter of the option symbol indicates the strike price. Again there are codes to
decipher the strike price.
Strike Price Codes
A
5
105
205
305
N
70
170
270
370
B
10
110
210
310
O
75
175
275
375
C
15
115
215
315
P
80
180
280
380
Q
85
185
285
385
D
20
120
220
320
R
90
190
290
390
E
25
125
225
325
S
95
195
295
395
F
30
130
230
330
T
100
200
300
400
G
35
135
235
335
U
7.50
37.50
67.50
97.50
H
40
140
240
340
V
12.50
42.50
72.50
102.50
I
45
145
245
345
W
17.50
47.50
77.50
107.50
J
50
150
250
350
K
55
155
255
355
X
22.50
52.50
82.50
112.50
L
60
160
260
360
Y
27.50
57.50
87.50
117.50
M
65
165
265
365
Z
32.50
62.50
92.50
122.50
By using the above information we can decipher the option symbol MSQLM:
The MSQ is the Root identifying Microsoft, the "L" is for the month of December
and it also let's us know that the option is a call option.
The last letter "M" tells us the option is for the 65 strike price.
Don't worry about remembering or memorizing all the codes. They are readily available
and easily obtained when you need them.
One more example, let's examine the option symbol CAH:
The last letter tells us the strike. You have an idea where a stock trades to know the
strike. For instance, the letter "B" could be for the strike price of 40, 140, 240, 340,
etc. In this case the letter "H" is for the strike price of 40.
The letter "A" is for the month of January and indicates a call;
And the letter "C" is the root symbol for the stock of Citicorp as well as the stock
symbol.
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Introduction
Options "Greeks" are sensitivities of the option to various exposures of risk including time
decay and volatility. The names are taken from the actual Greek names.
Greek
Delta
Δ
Gamma
Γ
Theta
Θ
Vega
Κ
Rho
Ρ
Zeta
Ζ
Sensitivity to
Change in option price relative to change in underlying asset price (ie
Speed)
Change in option Delta relative to change in underlying asset price (ie
Acceleration)
Change in option price relative to change in time left to expiration (ie
Time Decay)
Change in option price relative to the change in the asset's volatility
(ie Historical Volatility)
Change in option price relative to changes in the Risk Free Interest
Rate (ie Interest Rates)
Percent change in option price per 1% change in implied volatility (ie
Implied Volatility)
Delta - Δ
The Basics
The option delta is the rate of change of the option price compared with the rate of
change of the underlying asset price.
In other words delta measures the speed of the option position compared with that
of the underlying asset.
Delta =
rate of change in Option price
rate of change in underlying asset price
When the asset price is At the Money (ATM) the delta value will be around 0.5 (as
a general rule). This means that for every $1 the stock moves, the option will
move at a speed of around half of that. Obviously as the asset price deviates away
from the ATM point, then the delta will change too, away from 0.5.
ATM = +/- 50 deltas, ie moves at half the speed of the underlying asset
Remember that 1 share has a delta of +/- 1, and 1 option contract represents 100
shares, therefore 1 ATM option will have a delta of +/- 50.
You can think of delta as being the probability of the option expiring In the
Money. So a delta of +/- 50 is saying the option has a 50/50 chance of expiring In
the Money.
Example
If you buy 100 shares of AMZN (+100 deltas), you would need to buy 2 ATM Puts (-50
deltas each) for a Delta Neutral Position.
22
Delta Neutral Trading
Remember that Delta means speed. The greater the leverage of your position, the greater
potential exposure to speed. For example, if you buy a call option, the underlying stock may
increase by 10% whilst your call option may increase by 100%. This leverage is great when
it's in your favour, but not so good when it's against you. Taking the same example, if you
buy a call and the underlying stock decreases by 10%, your call options may decrease in
value by near 100%. This risk needs to be hedged. The term "hedge" is associated with the
process of reducing risk.
Delta Neutral Trading is a vast topic in itself, which will be covered in Special Article
sessions within this site. It is a method of trading whereby your position delta on the totality
of your spread trade is one where the sum of the deltas equals zero. The idea is that this
conveys a "hedged" position, whereby the risk is reduced.
Delta Neutral Traders do this on the basis that they can continually make profitable
adjustments to their trade as the asset price fluctuates. The adjustments (usually selling part
of the profitable side) bring the spread trade back to a delta neutral position (ie where the
sum of the deltas for that position equals zero), whilst also capitalising on profitable side of
the trade.
A popular technique is to make the profitable adjustments back to delta neutral when the
underlying asset has moved by 20% in either direction.
Remember that Delta Neutral does NOT mean risk free! Deltas are NOT linear.
Other points to remember
Delta Neutral still requires you to manage the Time Decay.
Longer term options will generally have lower deltas to shorter term options.
Your position Delta on your trade is also known as your "Hedge Ratio".
Delta is principally affected by Time left to expiration and Price of the underlying
asset.
Some futures Delta neutral trades can require no margin sometimes (and with
certain brokers)
With calls, Delta increases as the underlying asset price increases. Call deltas are
always positive. Note that when you sell a call (naked) your position is delta
negative.
With puts, Delta decreases as the underlying asset price decreases. Put deltas are
always negative. Note that when you sell a put (naked) your position is delta
positive.
23
Delta Trading
TRADE (US stock
options)
Buy 1 share
Sell 1 share
Buy ATM call
Buy Call
Sell ATM call
Sell Call
Buy ATM put
Sell ATM put
Buy Put
Sell Put
ATM Straddle
ATM Strangle
Bull spreads
Bear spreads
DELTA
COMMENT
(+ or -)
+1
Buying a share has a delta of +1
-1
selling a share has a delta of -1
Why +50? Because 1 stock option contract represents 100
+50
shares. So 100 * 0.5 = +50
+
A long call always has a positive delta
Why -50? Because 1 stock option contract represents 100
-50
shares. So 100 * -0.5 = -50
A short call always has a negative delta
Why -50? Because 1 stock option contract represents 100
-50
shares. So 100 * -0.5 = -50
Why +50? Because 1 stock option contract represents 100
+50
shares. So 100 * 0.5 = +50
A long put always has a negative delta
+
A short put always has a positive delta
The long call delta and long put delta effectively cancel each
0
other out
The long call delta and long put delta effectively cancel each
0
other out
With a Bull Call Spread, the long call has a higher delta than
the short call. With a Bull Put Spread, the short put has a
+
higher negative delta than the long put, but remember that
because you're selling it, 2 minuses make a plus.
With a Bear Call Spread, the short call has a higher delta than
the long call, but the delta is negative because you're selling
it. With a Bear Put Spread, the long put has a higher negative
delta than the short put.
Example: (Bull Call spread)
XYZ = $100
Buy 10 Jan 100c
Sell 10 Jan 105c
Delta = +500
Delta = -470 (say)
Hedge Ratio = +30
24
Why Does Speed Matter?
Example
You buy 100 shares of a stock. Each $1.00 your stock rises, you make $100 * $1.00
= $100. Each $1.00 your stock falls, you lose $100.
Alternatively, by buying call options you could make $300 when your stock rises by
$1.00? However, you can also lose $300 for every dollar the stock falls?
This is the concept of leverage.
You buy a stock at $50.00. Buying 100 shares costs you $5,000.
Let's compare this to buying the equivalent in call options: 1 contract at $7.00 will
cost you $700. (remember that 1 contract represents 100 shares for US stocks)
For illustration purposes only , let's say that your Delta is 1, ie for every one point
the stock moves, the call option you've bought also moves by 1 point.
If the stock rises from $50 to $55:
Your shares will increase by $5.00 per share and you'll make $500 in extra profit, a
profit of 10%.
Your calls will increase by $5.00 and you'll make $500 in profit, a profit of over
170%.
If the stock falls from $50 to $45:
Your shares will decrease by $5.00 per share and you'll lose $500, a loss of 10%.
Out of the $5,000 you started with, you now have $4,500.
Your options will decrease by $5.00 and you'll lose $500, a loss of over 70%. Out
of the $700 you started with, you now only have $200.
Can you now see why we might want to do something about the speed of the options price
movements and why we might want to offset (or hedge) Delta?
When we buy an option, we always want enough time to be right. We also want to make
sure that modest swings in the stock price aren't causing uncomfortably fast and wild
movements in our options position. This is why we want to hedge Delta, or in other
words, slow down the speed of the percentage movement of our options position
compared with that of the underlying asset.
25
Delta Picture Summary
Figures assume trading 1 contract
Gamma - Γ
Gamma measures Delta's sensitivity to changes in the stock price, in other words
"the speed of speed" or acceleration of the options position.
Gamma =
rate of change in Delta
rate of change in underlying asset price
By knowing the Gamma of an option, we know how quickly the Delta will change
and how quickly we should adjust our position in advance of this.
Gamma is significant because it helps the trader measure risk, particularly for Delta
Neutral Traders. Gamma effectively shows us how quickly the odds change of the
option expiring in the money.
Gamma tends to be large when the option is Near the Money (NTM). This means
that the Delta is highly sensitive (when the option is NTM) to changes in the stock
price. In other words the odds of the option changing from being OTM to ITM or
vice versa are high. Therefore, it is logical that ATM options have higher Gammas.
When options are Deep In the Money (DITM), the Delta is close to 1 and is not too
sensitive itself to changes in the underlying asset price. Therefore, the Gamma of
DITM options is low.
Similarly, Gamma is low for Deep Out of the Money (DOTM) options.
The Gamma for puts and calls is always identical and can be positive or negative.
Underlying Asset Price
ATM
NTM
Deep ITM
Deep OTM
Delta
Around 0.5
Around 0.5
Around 1 (high)
Low
Gamma
High
High
Low
Low
26
Gamma Picture Summary
Theta - Θ
Theta is the measure of how Time Decay affects the option premium. We already know
that the shorter the time to expiration, the lower the Time Value of an option, therefore the
lower the time value portion of the option price will be.
4 ways to combat Theta (Time) Decay
1. sell off any ATM or OTM options with 30 days left to expiration - do not hold
options into the last month
2. sell options as an adjustment to existing positions
3. sell options you don't own as an adjustment to existing positions
4. buy short-term DITM options, which have plenty of Intrinsic Value and virtually no
Time Value - if there is no Time Value, then it can't decay any further, can it?!
27
Theta Picture Summary
Vega - Κ (also known as Kappa or Lambda)
When you trade stocks, you must be aware of volatility. Volatility is also
recognised as risk.
Higher volatility is predicated by larger price fluctuations, which translates into
greater risk.
The greater the volatility and risk, the higher the options premiums will be.
Volatility is expressed as a percentage, reflecting the average or expected price
change (regardless of the direction).
If a stock is currently priced at $100 and has a (Historical) Volatility of 20%, then
that stock will be expected to trade within the range of $80 - $120.
Vega measures an option's sensitivity to Historical Volatility (measured by standard
deviation) of the underlying asset price.
Vega is always positive and is identical for both calls and puts.
28
Implied and Historical Volatility
There are two types of Volatility that you need to understand for options trading:
Historical Volatility and Implied Volatility.
Remember that there are 7 variables that affect an option's premium. Six of these
variables are known with certainty: (1) stock price; (2) strike price; (3) type of option; (4)
time to expiration; (5) interest rates; (6) dividends. The final variable is not known with
certainty and is the expected volatility of the stock. This expected volatility figure is
expressed as an annualised standard deviation and, working back from the option premium
itself, is an "implied" figure, hence Implied Volatility. Historical Volatility is the
annualized standard deviation of past price movements of the stock. We use Historical
Volatility as a reference figure for calculating what the Fair Value of the option should be,
given the stock's Historical Volatility. In the real world, option premiums frequently trade
away from their fair values.
Volatility
Historical (or
Statistical)
Implied
Look for
Implied > Historical
Historical > Implied
Based on the underlying asset volatility over past (20-23 trading
days is popular)
Expressed as a % reflecting the average annual range (ie standard
deviation)
Based on the option's actual price (premium), expressed as a % and
based on the perception of where market will be in the future
This is the volatility figure derived from the Black-Scholes options
pricing formula
Comment
Options prices could be overvalued as a result of higher implied
volatility (look to sell options)
Options prices could be undervalued, indicating good buying
opportunities, particularly if you anticipate asset price movement
Generally, Implied Volatility will veer towards Historical over the
medium to longer term - this is known as the "Rubber Band Effect"
Bollinger Bands are a good visual representation of volatility
29
About Volatility
Q. What does Historical Volatility mean?
A. It is a reflection of how the underlying asset has moved in the past (often 20-23
trading days)
Example:
XYZ = $200 and has Historical Volatility of 10%
Volatility Smiles and Skews
Volatility Smile
A Volatility Smile occurs where the Near the Money options have lower Implied
Volatility than the Deep ITM and Deep OTM options. When plotted on a chart, the
Implied Volatility against strike price graph appears to be in the shape of a smile.
It is not always clear why this occurs, but factors can include illiquidity leading to
mispricing for Deep ITM and Deep OTM options.
30
Volatility Skew
A Volatility Skew occurs where there is a difference in Implied Volatility between
OTM calls and puts. The reasons for Volatility Skew are not always obvious,
however, factors include market sentiment and supply and demand.
Vega Picture Summary
Rho - Ρ
Rho is the measure of an option's sensitivity to a 1% move in the Risk Free Interest
Rate.
Call Rho is always positive (helpful) and Put Rho is always negative (unhelpful).
Even large changes in interest rates have relatively little effect on options prices.
Rho is generally considered to have the least impact of the options Greeks,
particularly in a low interest rate environment.
Rho Picture Summary
31
Stock Options Strategy Guides
Stock Options Strategy Guide - Straddle
Description
Buy ATM put
Buy ATM call
Straddle
Steps to trading a Straddle
1. Buy a put;
2. Buy a call with the same expiration date and same strike price.
Steps In
Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily Volume
(ADV)
Actively seek chart patterns which appear like pennant formations, signifying a consolidating
price pattern
Try to concentrate on stocks with news events and earnings reports about to happen within 2
weeks
Avoid stocks under $20.00 You need adequate space for a big move in either direction.
Use the Analyzer to verify current market data and calculations
Steps Out
Manage your position according to the rules defined in your Trading Plan
Exit either a few days after the news event occurs where there is no movement, or after the
news event where there has been profitable movement.
If the stock thrusts up, sell the call (making a profit for the entire position) and wait for a
retracement to profit from the put
If the stock thrusts down, sell the put (making a profit for the entire position) and wait for a
retracement to profit from the call
Never hold into the last month
Your Outlook
With Straddles, your outlook is direction neutral but you are looking for increasing
volatility with the stock price moving explosively in either direction.
Rationale
To execute a neutral trade for a capital gain whilst expecting a surge in volatility.
Ideally you are looking for a scenario where Implied Volatility is currently very
low, giving you low option prices, but the stock is about to make an explosive move
- you just don't know which direction.
32
Net Position
This is a net debit trade.
Your maximum risk on the trade itself is limited to the net debit of the bought calls
and puts. Your maximum reward is potentially unlimited.
Effect of Time Decay
Time decay is harmful to your Straddle trade. Never keep a Straddle into the last
month preceding expiration because this is the time when time decay accelerates the
fastest.
Appropriate Time Period to Trade
You want to combine safety with prudence on cost. Therefore the optimum time
period to trade straddles is with 3 months till expiration, but if the stock has not
moved decisively sell your position when there is one month to expiration. NEVER
HOLD A STRADDLE INTOTHE LAST MONTH.
Selecting the Stock
Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily
Volume (ADV)
Actively seek chart patterns which appear like pennant formations, signifying a
consolidating price pattern
Try to concentrate on stocks with news events and earnings reports about to happen
within 2 weeks
Avoid stocks under $20.00 You need adequate space for a big move in either
direction.
Use the Analyzer to verify current market data and calculations
Selecting the Option
Choose options with adequate liquidity, open interest should be at least 100,
preferably 500
Strike: ATM for call and put
Expiration: preferably around 3 months. Same expiration for both legs.
Maximum Risk
Maximum Reward
Breakeven to the Downside
Breakeven to the Upside
Limited to the net debit paid
Uncapped
strike price plus net debit
strike price less net debit
33
The Greeks
Expiration
Today - 3 months
Time(t) - 1 month
Theta
Time Decay is most harmful to the position
at the strike where the position is
unprofitable.
Delta
Vega
Delta (speed) is at its
greatest when the position
is deep ITM on either
side. The position is
Delta Neutral around the
strike price
Volatility is most
helpful to the position
at the strike where the
position is most
unprofitable.
Gamma
Rho
Gamma (acceleration) peaks at the strike price,
illustrating the position's turning point and
Higher interest rates are generally helpful to
Delta's fastest rate of change. Gamma slows to the position when the underlying stock price
zero when the position is deep ITM on either
is above the strike price and vice versa.
side.
Exiting the Position
With this strategy you can simply unravel the spread by selling your calls and puts.
You can also exit just your profitable leg of the trade and hope that the stock
retraces to favour the unprofitable side later on. For example if the share has moved
decisively upwards, thus making the call profitable, you will sell the calls, make a
profit on the entire trade, but you will be left with almost valueless puts. Having
now sold the calls you will hope that the stock may retrace and enhance the value of
the puts you are still holding, which you can then sell.
Mitigating a loss
Sell the position if you only have one month left to expiration. Do not hold on in
hope because you risk losing your entire stake.
Advantages
Profit from a volatile stock moving in either direction
Capped risk
34
Uncapped profit potential if the stock moves
Disadvantages
Expensive - you have to buy the ATM call and put
Significant movement of the stock and option prices required to make a profit
Bid / Ask Spread can adversely affect the quality of the trade
Psychologically demanding strategy
Notes
It is preferable to enter Straddles shortly before earnings announcements
In a perfect Straddle world you'll find options that are trading at lower than their
average Implied Volatility levels but where you expect increasing volatility levels
for the duration of your trade.
Typically, we're looking for pennant formations or consolidation patterns on the
daily charts, with the expectation that there will be a price breakout.
90 day rule: look for the cost of the Straddle to be less than half the difference
between the highest high and lowest low during the last 3 trading months.
Stock Options Strategy Guide - Strangle
Description
Buy OTM lower strike put
Buy OTM higher strike call
Strangle
Steps to trading a Strangle
1. Buy a put;
2. Buy a call with the same expiration date but a HIGHER strike price.
Steps In
Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily Volume
(ADV)
Actively seek chart patterns which appear like pennant formations, signifying a consolidating
price pattern
Try to concentrate on stocks with news events and earnings reports about to happen within 2
weeks
Avoid stocks under $20.00 You need adequate space for a big move in either direction.
Use the Analyzer to verify current market data and calculations
Steps Out
Manage your position according to the rules defined in your Trading Plan
35
Exit either a few days after the news event occurs where there is no movement, or after the
news event where there has been profitable movement
If the stock thrusts up, sell the call (making a profit for the entire position) and wait for a
retracement to profit from the put
If the stock thrusts down, sell the put (making a profit for the entire position) and wait for a
retracement to profit from the call
Never hold into the last month
Your Outlook
With strangles, your outlook is direction neutral but you are looking for increasing
volatility with the stock price moving decisively in either direction.
Rationale
To execute a neutral trade for a capital gain whilst expecting a surge in volatility.
Ideally you are looking for a scenario where Implied Volatility is currently very
low, giving you low option prices, but where the stock is about to make an
explosive move - you just don't know which direction.
Strangles are cheaper than Straddles because you are buying OTM options on both
sides, as opposed buying ATM options (as with Straddles). This also has the effect
of widening your breakeven points.
Net Position
This is a net debit trade.
Your maximum risk on the trade itself is limited to the net debit of the bought calls
and puts. Your maximum reward is potentially unlimited.
Effect of Time Decay
Time decay is harmful to your Strangle trade. Never keep a Strangle into the last
month preceding expiration because this is the time when time decay accelerates the
fastest.
Appropriate Time Period to Trade
You want to combine safety with prudence on cost. Therefore the optimum time
period to trade strangles is with 3 months till expiration, but if the stock has not
moved decisively sell your position when there is one month to expiration. NEVER
HOLD A STRANGLE INTO THE LAST MONTH.
Selecting the Stock
Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily
Volume (ADV)
Actively seek chart patterns which appear like pennant formations, signifying a
consolidating price pattern
36
Try to concentrate on stocks with news events and earnings reports about to happen
within 2 weeks
Avoid stocks under $20.00 You need adequate space for a big move in either
direction.
Use the Analyzer to verify current market data and calculations
Selecting the Option
Choose options with adequate liquidity, open interest should be at least 100,
preferably 500
Put Strike: below the current stock price
Call Strike: above the current stock price
Expiration: preferably around 3 months. Same expiration for both legs.
Maximum Risk
Maximum Reward
Breakeven to the Downside
Breakeven to the Upside
Limited to the net debit paid
Uncapped
Lower (put) strike less net debit paid
Higher (call) strike plus net debit paid
The Greeks
Expiration
Today - 3months
Time(t) - 1 month
Theta
Time Decay is most harmful to the position
between the strikes where the position is at its
most unprofitable.
Delta
Vega
Delta (speed) is at its
greatest when the
position is deep ITM on
either side. The position
is Delta Neutral between
the strike prices
Volatility is most
helpful to the position
between the strikes
where the position is at
its most unprofitable.
Gamma
Rho
Gamma (acceleration) peaks around the
Higher interest rates are generally helpful to
37
strikes, illustrating the position's turning area
and Delta's fastest rate of change. Gamma
slows to zero when the position is deep ITM
on either side.
the position when the underlying stock price
is above the mid point between the strikes and
vice versa.
Exiting the Position
With this strategy you can simply unravel the spread by selling your calls and puts.
You can also exit just your profitable leg of the trade and hope that the stock
retraces to favour the unprofitable side later on. For example if the share has moved
decisively upwards, thus making the call profitable, you will sell the calls, make a
profit on the entire trade, but you will be left with almost valueless puts. Having
now sold the calls you will hope that the stock may retrace and enhance the value of
the puts you are still holding, which you can now sell.
Mitigating a loss
Sell the position if you only have one month left to expiration. Do not hold on in
hope because you risk losing your entire stake.
Advantages
Profit from a volatile stock moving in either direction
Capped risk
Uncapped profit potential if the stock moves
Cheaper than a Straddle
Disadvantages
Significant movement of the stock and option prices required to make a profit
Bid / Ask Spread can adversely affect the quality of the trade
Psychologically demanding strategy
Notes
It is preferable to enter Strangles shortly before earnings announcements
In a perfect Strangle world you'll find options that are trading at lower than their
average Implied Volatility levels but where you expect increasing volatility for the
duration of your trade.
Typically, we're looking for pennant formations or consolidation patterns on the
daily charts, with the expectation that there will be a price breakout.
38
Stock Options Strategy Guide - Long Call
Description
Steps to buying a call
1. Buy the call
Remember that for option contracts in the US, one contract is for 100 shares. So when you
see a price of $1.00 for a call, you will have to pay $100 for one contract.
For option contracts in the UK, one contract is for 1,000 shares, so if the option price is $1.00
you will pay $1,000 for one contract.
For S&P Futures options, one contract is for 250 futures, so if the option price is $1.00, you
will pay $250 for one contract.
Steps In
Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily Volume
(ADV)
Try to ensure that the trend is upward and identify a clear area of support
Use the Analyzer to verify current market data and calculations
Steps Out
Manage your position according to the rules defined in your Trading Plan
Do not keep the position into the final month before expiration
If the stock falls below your stop loss, then exit by selling the calls.
Your Outlook
Bullish - you are expecting a rise in the stock price
Rationale
To make a better return than if you had simply bought the stock itself. Do ensure
that you give yourself enough time to be right; this means you should go AT
LEAST 6 months out, if not 1 or 2 year LEAPs. If you think these are expensive,
then simply divide the price by the number of months left to expiration, and then
compare that to shorter term option prices. You will see that LEAPs and longer term
options are far better value per month and they give you more time to be right, thus
improving your chances of success. Another method is to buy only deep ITM
options.
39
Net Position
This is a net debit trade because you are paying for the call option
Your maximum risk is limited to the price you pay for the option
Your maximum reward is unlimited
Effect of Time Decay
Time works against your bought option. So give yourself enough time to be right.
Don't be fooled by the false economy that shorter options are cheaper. Compare a
one month option to a 12 month option and divide the longer option price by 12.
You will see that you are paying far less per month for the 12 month option.
Give yourself time to be right; this means at least 3 months, preferably more.
Appropriate Time Period to Trade
6 months minimum
12 months is better
24 months or more is the safest
Selecting the Stock
Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily
Volume (ADV)
Try to ensure that the trend is upward and identify a clear area of support
Use the Analyzer to verify current market data and calculations
Selecting the Option
Choose options with adequate liquidity, open interest should be at least 100,
preferably 500
Strike: look for look for either the ATM or ITM (lower) strike below the current
stock price
Expiration: give yourself enough time to be right; remember that time decay
accelerates exponentially in the last month before expiration, so give yourself a
minimum of 3 months to be right, knowing you'll never hold into the last month.
That gives you at least 2 months to be right, though preferably you'll choose over 6
months to expiration.
Maximum Risk
Maximum
Reward
Breakeven
Limited to the amount you pay for the call option (premium)
Uncapped
The call exercise (strike) price plus the premium you paid for it
40
The Greeks
Expiration
Today - 6 months
Time(t) - 1 month
Theta
Theta is negative, illustrating that Time
Decay is harmful to the position. Notice
how Theta Decay is at its most harmful
when the position is ATM.
Delta
Vega
Delta (speed) is positive and
rises as the asset price rises
above the strike price. Notice
how Delta is zero when the
position is Deep OTM,
accelerates exponentially
when the position is ATM,
and stabilises to one (per
contract) when the position is
Deep ITM.
Gamma
Vega is positive,
illustrating that
volatility is helpful
to the position.
Notice how
volatility is at its
most helpful when
the position is
ATM.
Rho
Gamma (acceleration) is always positive with a
Long Call and peaks when the position is ATM.
Notice how Gamma is lower when the position is
deep ITM or OTM.
Rho is positive, illustrating that higher
interest rates would be helpful to the
position.
Exiting the Position
Sell the options you bought
Mitigating a loss
Use stop losses
Advantages
Cheaper than buying the stock outright
Leverage of returns
Flexibility of strikes and expirations
Capped downside
Disadvantages
Potential 100% loss if badly chosen strike and expiration. Give yourself enough
time to be right and do not buy OTM.
High leverage can be dangerous if the stock falls
41
Stock Options Strategy Guide - Long Put
Description
Steps to buying a Put
1. Buy the put
Remember that for option contracts in the US, one contract is 100 puts. So when you see a
price of $1.00 for a put, you will have to pay $100 for one contract.
For option contracts in the UK, one contract is for 1,000 shares, so if the option price is $1.00
you will pay $1,000 for one contract.
For S&P Futures options, one contract is for 250 futures, so if the option price is $1.00, you
will pay $250 for one contract.
Steps In
Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily Volume
(ADV)
Try to ensure that the trend is downward and identify a clear area of resistance
Use the Analyzer to verify current market data and calculations
Steps Out
Manage your position according to the rules defined in your Trading Plan
Do not keep the position into the final month before expiration
If the stock rises above your stop loss, then exit by selling the puts.
Your Outlook
Bearish - you are expecting a fall in the stock price
Rationale
To make a better return than if you had simply sold short the stock itself. Do ensure
that you give yourself enough time to be right; this means you should go AT
LEAST 6 months out, if not 1 or 2 year LEAPs. If you think these are expensive,
then simply divide the price by the number of months left to expiration, and then
compare that to shorter term put prices. You will see that LEAPs and longer term
options are far better value per month and they give you more time to be right, thus
improving your chances of success. Another method is to buy only deep ITM
options.
42
Net Position
This is a net debit trade because you are paying for the put option
Your maximum risk is limited to the price you pay for the option
Your maximum reward is unlimited until the stock falls to zero, whereupon your
maximum reward is the strike price less the premium you paid for the put.
Effect of Time Decay
Time works against your bought option. So give yourself enough time to be right.
Don't be fooled by the false economy that buying shorter dated options are cheaper.
Compare a one month option to a 12 month option and divide the longer option
price by 12. You will see that you are paying far less per month for the 12 month
option.
Give yourself time to be right; at least 3 months, preferably longer..
Appropriate Time Period to Trade
6 months minimum
12 months is better
24 months is the safest
Selecting the Stock
Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily
Volume (ADV)
Try to ensure that the trend is downward and identify a clear area of resistance
Use the Analyzer to verify current market data and calculations
Selecting the Option
Choose options with adequate liquidity, open interest should be at least 100,
preferably 500
Strike: look for look for either the ATM or ITM (higher) strike above the current
stock price
Expiration: give yourself enough time to be right; remember that time decay
accelerates exponentially in the last month before expiration, so give yourself a
minimum of 3 months to be right, knowing you'll never hold into the last month.
That gives you at least 2 months to be right.
Maximum
Risk
Maximum
Reward
Breakeven
Limited to the amount you pay for the put option (premium)
Unlimited up to the strike price less the amount you paid for the put.
Before expiration this could actually be more because of Time Value.
The put exercise (strike) price less the premium you paid for it
43
The Greeks
Expiration
Today - 6 months
Time(t) - 1 month
Theta
Theta is negative, illustrating that Time
Decay is harmful to the position. Notice
how Theta Decay is at its most harmful
when the position is ATM.
Delta
Vega
Delta (speed) is negative and
falls as the asset price falls
below the strike price. Notice
how Delta is zero when the
position is deep OTM,
accelerates inversely
exponentially when the
position is ATM, and
stabilises to minus one (per
contract) when the position is
deep ITM.
Gamma
Vega is positive,
illustrating that
volatility is helpful
to the position.
Notice how
volatility is at its
most helpful when
the position is
ATM.
Rho
Gamma (acceleration) is always positive with a
Long Put and peaks when the position is ATM.
Notice how Gamma approaches zero when the
position is deep ITM or OTM.
Rho is negative, illustrating that higher
interest rates would be harmful to the
position.
Exiting the Position
Sell the options you bought
Mitigating a loss
Use the underlying asset or stock to determine where your stop loss should be
placed.
Advantages
Profit from declining stock prices
Leverage of returns
Flexibility of strikes and expirations
Capped downside
Disadvantages
Potential 100% loss if badly chosen strike and expiration. Give yourself enough
time to be right and do not buy OTM.
High leverage can be dangerous if the stock rises
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