Option Basics
Introduction to Options
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Option Basics
Introduction to Options __________________________________________________________ 1
Option Definitions ______________________________________________________________ 4
Call Options________________________________________________________________________ 4
Put Options ________________________________________________________________________ 4
Option Contract ____________________________________________________________________ 4
Strike Price ________________________________________________________________________ 4
Expiration Date _____________________________________________________________________ 5
Premium __________________________________________________________________________ 5
Option Market Maker _______________________________________________________________ 5
Open Interest _______________________________________________________________________ 5
Volume ____________________________________________________________________________ 5
Assignment ________________________________________________________________________ 5
Historic Volatility ___________________________________________________________________ 5
Intrinsic value ______________________________________________________________________ 5
Extrinsic value ______________________________________________________________________ 5
Time Value ________________________________________________________________________ 5
At The Money (ATM) ________________________________________________________________ 5
In The Money (ITM) ________________________________________________________________ 6
Out Of The Money (OTM) ____________________________________________________________ 6
Pricing & Volatility _____________________________________________________________ 6
Pricing ____________________________________________________________________________ 6
Delta ______________________________________________________________________________ 6
Gamma____________________________________________________________________________ 6
Theta _____________________________________________________________________________ 6
Vega ______________________________________________________________________________ 6
Volatility __________________________________________________________________________ 6
Historical/Statistical Volatility (SV) ____________________________________________________ 7
Implied Volatility (IV) _______________________________________________________________ 7
Buying Long Call Options ________________________________________________________ 7
Swing Trades _______________________________________________________________________ 7
Option ROI Calculations _____________________________________________________________ 8
Bull Call Spreads _______________________________________________________________ 8
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Option Basics
Covered Calls ______________________________________________________________________ 9
LEAPS & Covered Calls on core holdings ______________________________________________ 10
Buying Put Options ____________________________________________________________ 10
Swing Trades ______________________________________________________________________ 10
Bear Put Spreads ______________________________________________________________ 11
Selling Call Options ____________________________________________________________ 11
Bear Call Spreads __________________________________________________________________ 12
Selling Put Options ____________________________________________________________ 12
Bull Put Spread ____________________________________________________________________ 13
Iron Condor __________________________________________________________________ 13
Long Straddles & Strangles ______________________________________________________ 14
Short Straddles & Strangles _____________________________________________________ 15
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Option Basics
Option Definitions
Call Options
Gives the holder (buyer) the right to buy (call away) the underlying stock from the seller (writer) at
a specific price (strike) but only for a specified amount of time (expiry).
Buyer
Max gain = unlimited
Max loss = premium paid
Seller
Max gain = premium paid
Max loss = unlimited unless covered calls or a spread
Example:
Qualcomm (QCOM) stock price = $39.60 @ Jan 1st
April 37.5 calls quoted at $3.30 (per share i.e. premium)
Intrinsic value = 39.6-37.5=$2.1 (ITM)
Extrinsic value = 3.3-2.1=$1.2 i.e. Option time value of $1.2
Put Options
Gives the holder (buyer) the right to sell (put) the underlying stock to the seller (writer) at a specific
price (strike) but only for a specified amount of time (expiry).
Buyer
Seller
Max gain = strike price - premium paid
Max loss = premium paid
Max gain = premium received
Max loss = strike price - premium paid
Example: Home Depot (HD) stock price = $38.60 @ April 1st
 April 40 puts quoted at $1.9 (per share i.e. premium)
 Intrinsic value = 40-38.6=$1.4 (ITM)
 Extrinsic value = 1.9-1.4=$0.5 i.e. Option time value of $0.5
Option Contract
The trading unit of Options. One contract controls 100 shares.
Strike Price
The predetermined price that the stock will be delivered in the event that the option is exercised.
 Stocks < $2.5 are not optionable
 Stocks $2.5-25 strikes are $2.5 apart.
 Stocks >$25 strikes are $5 apart.
 Stocks >$200 strikes are $10 apart.
 Exception indexes.
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Option Basics
Expiration Date
The last day that an option can be exercised 3rd Friday of the month.
Premium
The price paid when buying an option and is composed of intrinsic value and time value. Is quoted
per share i.e. The "cost basis"
Option Market Maker
Entity who provide liquidity and willing to buy at bid and sell at offer. There are four pit exchanges
CBO, PHS, PSE and ASE. Two electronic exchanges ISE and BSE. ISE preferred.
Open Interest
The number of contracts open at a particular strike price(both long and short).
Volume
The total number of contracts traded at a particular strike price.
Assignment
Options are auto assigned if in the money (ITM) by more than 0.01c at expiry.
Historic Volatility
Measures the annualized standard deviation in price of the underlying.
Implied Volatility
Attempts to predict the perceived price movement in the future. This is a key determinant of option
price. Amount of risk determines volatility.
Intrinsic value
Is the amount of money that can be realized if the option is exercised. The portion of an option that
is in the money.
Extrinsic value
Is the price of the possibility that the option will become intrinsic during its life.
Time Value
Is the difference between the option premium and its intrinsic value. Time Value is influenced by
the amount of time to expiration and volatility of the stock.
At The Money (ATM)
Option have a strike price at or near the current price of the stock option
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Option Basics
In The Money (ITM)
For call option ITM options have a strike price below the current price of the stock.
+ive = Current Price - Strike Price
For put options ITM options have a strike price above the current price of the stock
+ive = Strike Price - Current Price.
Out Of The Money (OTM)
Options have no intrinsic value all the value is time value.
Pricing & Volatility
Pricing
The following are used to calculate option prices. Strike price, expiration date, current stock price,
dividends, implied volatility. The Black Scholes Valuation model is used to price options. Options
are time depleting assets.
The terms applied to the calculations are called the Greeks: Delta (only use this), Theta, Gamma,
Vega.
Delta
Amount that an option changes with respect to a change in the underlying. Think of delta as the
probability of an option expiring ITM, so we look for deltas in the 85% range these are good for
swing trades. ATM options change price at half the rate and therefore have delta of 0.5. Options so
far OTM are considered worthless and have delta of 0. Delta ITM calls can be used as a cheaper
alternative to buying the stock.
Gamma
Measures how quickly or slowly the delta responds to a chnage in the underlying.
Theta
Is the amount the option decays in one day. A writer (seller) receives income from time delay and
therefore has positive theta, buyer has expense and therefore has negative theta. Theta accelerates
rapidly during the last 15 days.
Vega
Is the amount that an option changes if the implied volatility changes by 1%. A long option position
profits from an increase in the implied volatility and therefore has positive vega. Short option
position profits from a decrease in implied volatility and therefore has negative vega.
Volatility
A statistical measure of the dispersion of returns (standard deviation) for a given security or market
index. Refers to the amount of risk/uncertainty about the size of change in the securities value. Beta
approximates the stocks volatility against a bench mark usually S&P 500. So one standard
deviation encompasses 68% (of the bell curve), two 96% and three 99.9%.
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Option Basics
Historical/Statistical Volatility (SV)
Measured by taking the average daily % price changes and calculate the average over a given
period of time as a %. Short term traders use periods of 30days or less. Intermediate term use 1yr or
less.
Implied Volatility (IV)
The volatility the underlying would need to be for the option pricing model to produce the same
theoretical option price as the actual option price. This represents the markets expectation of future
price moves. Higher IV's mean market expects large price moves. Look for a pattern in the IV of
calls/puts this is called the skew of the IV. OTM options have higher IV's than ATM, because they
present more risk on large moves. The best candidates for covered call writing is when IV is much
greater than SV. If IV rises call and put premiums rise. Volatility will increase in anticipation of
upcoming events.
Expensive vs Inexpensive
 Higher IV percentile ranking = expensive
 IV over 70% are considered expensive favoring option shorting.
 IV under 30% are considered inexpensive, favoring option buying.
 Tip Sell these!
Overvalued vs Undervalued
 Overvalued is when IV is higher than SV.
 Undervalued is when IV is lower than SV.
 Tip purchase these!
Buying Long Call Options
For an agreed upon price (premium), Call options give the buyer (holder) the right to buy the stock
at a specific strike price on or before the expiration date. Is a bullish strategy, but only profit if the
stock rises.
Swing Trades
Best done with inexpensive and under priced options. Need sufficient time for the option to
perform. Max loss on any long position is the premium or cost basis. Unlimited gains.
 Recommend deltas over 85%
 Expiry need at least 2-5days
 Options should be fairly valued and low volatility
 Spread should be <20c, use LMT orders and try to go inside the spread
 Make sure no earnings or other know news events are close at hand
 Is there a 3:1 risk reward in the underlying price pattern
 Enter and exit the position at the same time you would have if you were trading the stock
 Unless short term trading ITM options with little TV. Do not swing trade long options
within two weeks of expiry.
Option exit scenarios
 99% you will sell to close. P/L = Sales Price - Cost basis
 Exercise an ITM option P/L = Stock Price - Strike - Premium paid.
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Option Basics
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Roll forward i.e. Sell to close and buy a new call with more time.
OTM options will expire worthless so loss is cost basis. Auto exercise if 0.05 ITM.
Option ROI Calculations
Total cahs outlay = cost basis (premium)
ROI = (gain or loss)/cost basis
Apr ROI = ROI*360/# days trade open
Example: Stock XYZ has a compelling PBS setup to buy over 72.73 and stop loss 70.63 ($2) with a
target of 3:1 $78.60. The position trail stops at 81.81 after a 5 day rally. Trade management
indicates to buy 1000 shares.
1/ Buy the underlying stock
P/L = $81800-$72630 = $9160 ROI = 12.6%
Max loss = $2000
2/ Buy 10 contracts, Jan 65 calls @ $8.10 nd sell at $15.2 when stopped
P/L = $8100-$15200=$7100. ROI = 87.6%
Max loss = sale price - $8100
3/ Buy 10 contracts, Jan 70 calls @ $5.60 nd sell at $11.6 when stopped
P/L = $5600-$11600=$6000. ROI = 107.1%
Max loss = sale price - $5600
Bull Call Spreads
Buy and sell the same type (call or put) of option on the same stock, with different expiry months,
exercise prices, or both. Considered a mildly bullish strategy.
 Bull spread purchase lower strike price than the one sold.
 Bear spread purchase the higher strike price than the one sold.
Done to reduce the risk of loss and cost. Legging into any spread can be more profitable. Stop out
of both (or losing) positions if stock violates stops.
Example: GOOG trading at $460.48
 Buy GOOG Jan 7th 440 calls @ $25.7
 Sell GOOG Jan 7th $480 calls @ $4.7
 Holder has the right to buy at 440 but the obligation to sell at 480
 Max gain if stock closes over 480 is 480-440-21=$19/share
 Max loss is cost basis i.e. 25.7-4.7=$21
 Breakeven = lower strike + debit = 440+21=461.
Exit Strategies
 Sell both positions (whether for gain or loss)
 Do nothing, if closes over the short call strike, will be auto-assigned
 If closes over the short strike and above the long strike, will be assigned the underlying.
 If the bullish pattern on the long equity fails, stop out of the long call, keeping the short call
open, with the intent of it expiring worthless.
 If the stock turns more bullish than anticipated, close the short call and keep the long call, to
participate in the upside.
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Option Basics
Covered Calls
Buy the stock and short one call for every hundred shares (aka buy-write or covered write). In
exchange for premium you are agreeing to let the call buyer buy the underlying at the strike price
on or before expiry. Considered a mildly bullish strategy. Covered means the writer has the
underlying to produce if assigned an exercise option. Goal is to sell the front month strike price that
will just expire worthless at expiry.
 Max gain is the short call strike price less cost basis (i.e. Purchase price of stock less
premium for call).
 Max loss is the cost basis (less than been long stock).
 Only disadvantage is strategy is limiting potential upside.
 Advantage lock in profits immediate.
 Generate monthly cash flow. Premium received acts as a partial hedge by lowering cost
basis
 Lower cost basis
 IRA approved.
Example: GOOG trading at $460.48. You decide to buy 100 shares @440.48 and sell Jan 480 call
@$4,7 for a net debit of 46048-470=$45578.
 Max gain 480,000-45578 = $2422 assuming GOOG closes over 480.
 Max loss 45578
Selecting OTM call in covered call:
 Select a strike price at which you think the stock will close near.
 Still acceptable to sell ATM or slightly ITM strike calls if you are pleased with the ROI if
called out.
 Close strike is more conservative (less bullish), with potential upside, but also deliver a
lower cost basis.
Exit Strategies for covered calls
 Sell both positions.
 Do nothing:
1. If closes over the short call strike, will be auto-assigned
2. If closes under the short strike you keep the stock.
 If the bullish pattern on the long equity fails, stop out of the long, keeping the short call
open, with the intent of it expiring worthless.
 If the stock turns more bullish than anticipated, close the short call and keep the long stock,
to participate in the upside.
 Roll the short call forward (stops the stock from being taken from the account) by:
1. Before the market closes you "buy to close" the short call.
2. To "roll forward" you then "sell to open" the next month call.
Other considerations:
 Don't write covered calls if very bullish on the chart since the short call limits the upside
potential.
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Option Basics
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Don't write deep ITM calls or cheap options, because T/V expires rapidly into expiration,
best to write short term calls.
Select a strike price at resistance at expiry.
Apply stop loss rules to both positions (or losing one)
Best done with over priced and expensive options.
LEAPS & Covered Calls on core holdings
Writing ATM or slightly OTM calls on core holdings after a multi-bar rally and then a short-term
bearish setup (BS) offers an excellent opportunity to reduce cost basis over time. If the chart
subsequently turns bullish you can:
 Buy to close the short call to prevent upside cap.
 Do nothing and let the stock be called away at the strike price.
 Wait for expiry and roll forward if ITM.
Example: Buy 1000 shares of XYZ, @$25 on 4/20, cost basis $25000. Assume the stock trades in a
range, so resistance is at $32 area and support is at $26 area for the 3 months. On each pull back we
can sell covered calls to reduce cost basis.
 Sell May 35 @1.5 on 4/20, cost basis = 25000-1500= $23500
 Sell June 35 @2.3 on 5/2, cost basis = 23500-2300= $21200
 Sell July 35 @2.8 on 6/10, cost basis = 21200-2800= $18400
 So ROI on 7/20 6600/25000 = 26% or cost basis now down to 18.6/share.
Buying Put Options
For an agreed upon price (premium), Put options give the buyer (holder) the right to sell the stock
at a specific strike price on or before the expiration date. Is a bearish strategy, but only profit if the
stock falls.
Swing Trades
Best done with inexpensive and under priced options. TV erodes against the option holders, so put
buyers need sufficient time before expiration for the stock to fall. Max profit is the strike price less
premium paid. Max loss on all long options is the cost basis.
 Recommend deltas over 85%
 Expiry need at least 2-5days
 Options should be fairly valued and low volatility
 Spread should be <20c, use LMT orders and try to go inside the spread
 Make sure no earnings or other know news events are close at hand
 Is there a 3:1 risk reward in the underlying price pattern
 Enter and exit the position at the same time you would have if you were trading the stock
 Unless short term trading ITM options with little TV. Do not swing trade long options
within two weeks of expiry.
Option exit scenarios
 99% you will sell to close. P/L = Sales Price - Cost basis
 Exercise an ITM put to sell stock at strike price P/L = Strike - Stock Price - Premium paid.
 Roll forward i.e. Sell to close and buy a new put with more time.
 OTM options will expire worthless so loss is cost basis. Auto exercise if 0.05 ITM.
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Option Basics
Bear Put Spreads
Buy and sell puts on the same stock, with different strike prices and or expiration months.
Considered a mildly bearish strategy. Best done with overpriced and expensive options, and when
you can leg into the short position after a multi bar drop.
 Buy puts strike price depends on how bearish you are.
 Sell puts with lower strike price than the one sold.
Done to reduce the risk of loss and cost. Legging into any spread can be more profitable. Stop out
of both (or losing) positions if stock violates stops.
Example: GOOG trading at $460.48. Bear spreas purchase the higher strike price than the one sold.
 Buy GOOG Nov 7th 510 puts @ $2.75
 Sell GOOG Nov 7th $500 calls @ $1.0
 Net debit = 2.75-1 = $1.75
 Max gain if stock closes below the lower strike price. 510-500-1.75 = 8.25/per share
 Max loss is cost basis i.e. 2.75-1 = $1.75
 Breakeven = higher strike - debit = 510+1.75=508.25.
Selling Call Options
Seller/Writer of a call has the obligation to sell 100 shares/contract of the underlying at the strike
price on or before expiry. This is a bearish or neutral strategy.
 Short call is covered only if the writer owns the underlying (i.e. covered call) or
 Is also long a call of the same class with equal or greater strike price (e.g. Bull call spread)
 Max gain premium received. So if stock sideways or down we win (67% of the time)
 Max loss unlimited.
 If mildly bearish short naked calls, sell call strike price just above resistance where you
think the stock will not trade above before expiry.
o If stock goes up through resistance then stop out
o or buy stock to hedge
o or let it get assigned to you and you are now short the stock with cost basis of strike
+ premium received.
 Max gain is the premium
 Max loss is unlimited, but less risk than been short the stock since the premium received
increases your cost basis if assigned the stock short.
 Best done with over priced and expensive options.
Option exit Strategies
 Buy to close when swing trading for speculation
 P/L = Purchase price - Cost basis
 Hedge roll forward if slightly ITM. Can close and roll to next month. Short OTM put as a
partial hedge (opposite covered call).
 Do nothing OTM options will expire worthless.
 Auto exercise if 0.05c ITM you will then be short the stock.
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Option Basics
Bear Call Spreads
Buy and sell calls on the same stock, with different strike prices and or expiration months.
Considered a mildly bearish strategy. Best done with overpriced and expensive options and when
you can leg into the short put position after multi bar drop.
Bear Call Spread:
 Sell call strike price just above resistance where you think the stock will not trade above
before expiry.
 Purchase higher strike call than the one sold as a hedge.
The difference between the premium received less the call purchased is a net credit i.e. Credit
spread.
Example: GOOG trading at 460.48
 Short GOOG Jan 7th 470 calls @$7.80
 Buy GOOG Jan 7th $490 @$3.00
 Net Credit 7.8-3 = $4.8
 Short call is covered only when the writer is also long the stock (i.e. covered call) or a call
of the same class with equal or greater strike price.
 Sell a call at the same strike that you believe the stock will not close above at expiration and
simultaneously buy a call with a higher strike for insurance to limit loss (net credit).
 Max gain is premium received if the stock closes below the lower strike price.
 Max loss is difference in strike prices less premium.
 Breakeven = Lower strike price + credit
 No cash outlay needed only margin for amount of risk.
Selling Put Options
Seller/Writer of a put has the obligation to buy 100 shares/contract of the underlying at the strike
price on or before expiry. This is a bullish or neutral strategy.
 Short put is covered only if the writer is also long a put of the same class with equal or
greater strike price (e.g. Bull put spread)
 Max gain premium received. So if stock sideways or down we win (67% of the time),
synthetic equivalent to a covered call.
 Max loss unlimited = Strike price - premium.
Selling high put premium options into expiry (Theta). Theta:
 It is the amount that the option decays in one day.
 A writer receives income from time decay and therefore has positive theta. A buyer incurs
an expense from time decay and therefore has negative theta.
 Into expiry we look to sell high premium puts on bullish patterns
o Look for fat premiums on quite stocks
o Overvalued options based on each options own recent MIV
o Stocks with historically high volatility
o Exceptional Put/Call volume ration
o Breakouts to the upside
 Consider also writing naked puts on those with very little likelihood of trading under price
at expiry
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Option Basics

Look for 1-2% for OTM puts into expiry.
Bull Put Spread
Buy and sell puts on the same stock, with different strike prices and or expiration months.
Considered a mildly bullish strategy since the gain is limited. Best done with overpriced and
expensive options and when expect the stock to chop around above short strike price.
 Sell put strike price just under support where you think the stock will not trade below before
expiry.
 Purchase lower strike call than the one sold as a hedge.
The difference between the premium received less the put purchased is a net credit i.e. Credit
spread.
Example: ORCL trading at $17.50
 Sell ORCL Jan Leap Puts $17.5 ATM @$1.48
 Buy ORCL Jan 7th $12.5 @$0.25
 Net Credit 1.45-0.25 = $1.20
 Short put is covered only when the writer is also long a put of the same class with equal or
greater strike price.
 Sell a put at the same strike that you believe the stock will not close above at expiration and
simultaneously buy a put with a lower strike for insurance to limit loss (net credit).
 Max gain is premium received if the stock closes above the higher strike price.
 Max loss is difference in strike prices less premium.
 Breakeven = Higher strike price - credit
 No cash outlay needed only margin for amount of risk.
Iron Condor
This is a neutral time decay option strategy consisting of OTM bear call spread and OTM bull put
spread. Average holding period is 2-6 weeks with intent to expire worthless.
 Max profit is net credit received
 Max loss occurs if closes beyond the outer options strike price.
 Breakevens: Upper b.e. is upper strike + credit: lower b.e. is lower strike - credit
 Great strategy for range bound stocks and indexes.
 Can leg in and out for bigger profits.
Example: Assume $OEX is trading at $590 on Oct 1st and has been range bound between 570
support and 610 resistance.
 OTM Bear Call spread, sell Oct 610 calls for $2.5 and buy Oct 620 calls for $1.0 netting
$1.5/share (upper vertical credit spread) and
 OTM Bull Put spread: Sell Oct 570 puts for $2.70 and buy Oct 560 puts for 1.6 netting
$1.6/share (lower vertical credit spread)
 Total credit received of $3.10/share is max gain, which you receive if $OEX closes between
570 and 610
 Breakeven points are 613.1 (upper strike + credit) and 536.9 (lower strike - credit)
 Max loss is the difference in strike prices ($10) less credit of $3.10 = $6.90/share.
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Option Basics
Long Straddles & Strangles
Long Straddle, buy calls and puts on the same stock, with the same strike prices and same
expiration dates.
 Total paid for the calls and puts is the cost basis (debit) and represents the max loss.
 Used in volatile markets or ahead of news events when wide swings in either direction are
expected , such as:
o Earnings
o Pending FDA announcements on new drugs
o Big litigation decisions
o Takeover speculation
 Betting on both sides of the market simultaneously: thus, considered a mildly bullish and
bearish strategy.
 Best done with under priced and inexpensive options and when have more time before
expiration.
 Note Strangles are identical to straddles except that different exercise prices are used.
 Max gain is unlimited because of the long call. To profit the stock must move far enough to
recover more than the total debit (premium.
 Breakevens are strike price plus total premium paid and strike price minus debit.
Long Strangle, buy calls and puts on the same stock, with different strike prices and the same
expiration date.
 Total premium paid for the long calls and puts is the debit and represents the max loss.
 Different strike prices are used (unlike straddles which use the same strike) to lower the
premium paid.
 Used in volatile markets or ahead of news events or when wide swings in either direction
are expected.
 Max gain is unlimited because of the long call or if gaps to zero on the downside.
 Max loss is the total premium paid.
 Breakevens are upper strike price plus premium paid and lower strike minus premium.
 Stock has to move a lot to recover the debit.
 Best done with under priced and inexpensive options (implied volatility will be high into
known reporting events.
ITM Strangles for expected big movers
 The rewards can overwhelm the risks to buy deep ITM calls and puts on volatile stocks
ahead of known big market movers provided the T/V paid is not big and the spread is 0.20
or less.
 Intent is to benefit from big movers with the gain on the winning side exceeding the losing
side.
 If small move at all then lose spread and small T/V
 If medium move (say 1 strike price) the should still be profitable because the gain on the
deep ITM option should outweigh the loss on the losing arm, which still has some IntV and
T/V.
Synthetic Equivalents, combining options with other options or underlying stocks to create
positions which are almost identical to some other contract.
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Option Basics
Synthetic
Long Call
Long Put
=
=
Equivalent to
Long stock + Long put
Short stock + Long call
The long and short stock cancel out giving us the benefit of betting on both side of the market with
the long call and put, provided you don't pay much T/V or spread.
Short Straddles & Strangles
Short strangle sell calls and puts on the same stock, with different strike prices and the same
expiration date.
 Total premium paid for the long calls and puts is the debit and represents the max loss
 Different strike prices are used (unlike straddles which use same strike) to give wider
breakeven.
 Used in low volatile markets.
 Considered a neutral strategy
 Max gain is total premium received
 Max loss is unlimited
 Breakeven are upper strike plus premium paid and lower strike minus premium.
 Stock has to move a lot to recover the debit
 Best done with over priced and expensive options and near expiration.
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