Key Terms for Options Trading
2022-06-08 | Simpler Trading Team
Trading options can be described as a zero-sum game, which is an essential concept for traders to grasp. While stocks give buyers a small piece of ownership in a company, options contracts give traders the “right” to buy or sell the stock at a specific price by a particular date. There are always two sides to every option transaction: the buyer and the seller. Trading options are similar to purchasing securities contracts, but there are differences traders should understand.
An options contract equals 100 stock shares of a particular asset. However, options do not provide any ownership in a company like a stock purchase. These contracts are in place only to allow a trader to buy or sell options on securities, such as stocks, at a predetermined price within a specific time period. The option buyer’s gain is the option seller’s loss and vice versa.
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Options Trading: Key Terms Simplified
An options contract does not require that the purchaser buy or sell the underlying security; this contract can involve stocks, bonds, futures, or exchange-traded funds (ETFs). Options contracts are purchased on the options market through a trading platform or a broker.
The price of an option, called the premium, has variables that determine the amount paid by the buyer. One of the key drivers for an option’s premium is the intrinsic value – how much of the premium is made up of the price difference between the current stock price and the strike price.
The intrinsic value for a call option is calculated by subtracting the strike price from the current stock price. The intrinsic value for a put option, on the other hand, is calculated by subtracting the current stock price from its strike price at expiration.
The extrinsic value is calculated by taking the difference between the market price of an option (or the premium) and its intrinsic price – the value of an options contract in relation to the underlying at expiration or if exercised. This price is less tangible and is based more on time values than other factors.
The extrinsic value will be higher when there is more time left. As a contract moves toward the expiration date, the extrinsic value will typically decrease due to time decay, and there’s less time for the underlying security price to move. An option is considered a derivative security as the price of the option is derived from an underlying security.
The key points to remember when considering an options trade are:
Buying a call option is used when a trader expects the stock price to rise. Buying put options indicates that the trader expects the stock price (or another asset) to fall. Remember, options traders purchase the “option” to buy or sell at a predetermined price point at a future date.
There are some attractive features of trading options. For example, the cost of an option can be much less than the purchase price of common stock. Traders with smaller accounts can access expensive stocks by purchasing options.
Should a trader want to invest in Google, which has a strong reputation, they will quickly find the stock price unaffordable for a small account. It’s important to remember that traders should limit their risk by only trading a set percentage of their trading account as a part of their trading plan. Traders generally risk no more than 5% of the entire trading account with any trade, although traders can risk more or less depending on their risk appetite, setups, and market outlook.
The purchase of 100 shares of Google at $2,000 would cost $200,000 plus commissions and fees. A drop in the stock price would result in significant losses. You can see how this scenario could be disastrous for a small trading account.
Options trades are a much more affordable alternative. Should a trader use in-the-money call options that mimic the movement of the stock, they can benefit from not only a cheaper trade entry but the ability for the trade to expire worthless if the stock does not hit the strike price.
Not only do options often trade at a fraction of the price of the actual shares, but if you owned a call option of 100 shares of Google, you would have only lost the premium paid. Also, whether the trader loses money – or makes money – on the purchase, the option purchase expires in a matter of days. Options trading provides market access and faster profit potential for traders.
The indexes can be traded as an options trade as well. The difference between an index of stocks and a single stock (or asset) is a risk. Stock options are based on a single company’s stock, while index options are based on a basket of stocks that represents a particular segment of the overall market.
Understanding Options Trades
Options can be in-the-money (ITM), out-of-the-money (OTM), or at-the-money (ATM). In-the-money means the option has an intrinsic value, and out-of-the-money means it doesn’t. At-the-money options are not yet positioned to profit if exercised; however, if they have not expired, they could end up in the money before they do.
Traders most often use at-the-money options to construct butterfly spreads and other combinations that allow for minimizing risks. Call and put options and look for different results at the expiration date.
- A call option (option to purchase) is in-the-money when the option’s strike price is less than the current stock (or asset) price. Conversely, a put option (option to sell) is in-the-money when the option’s strike price is greater than the stock price.
- A call option (option to purchase) is out-the-money when its strike price is greater than the current underlying security’s price, and a put option (option to sell) is out-the-money when its strike price is less than the current stock price.
ATM options are the most sensitive to various risk factors, known as an option’s “Greeks.” At-the-money options have a ±0.50 delta but the most significant amount of gamma, meaning the stock price moves. Its delta will move away from ±0.50 rapidly and even more quickly as expiration nears.
At-the-money options are generally more sensitive to time decay, as represented by an option’s theta. Options that have prices that are more responsive to changes in volatility, especially for further expirations, are expressed by an option’s vega. The vega of stock options measures the rate of change in implied volatility.
At-the-money options are sensitive to changes in interest rates, as measured by the rho. While the formula to calculate rho is complicated, this is essentially the rate at which the price of derivative changes relative to a change in the risk-free rate of interest. Rho measures the sensitivity of an option or options portfolio to a change in interest rate, although it is one of the least used Greek option metrics.
The term “near-the-money” is sometimes used to describe an option within 50 cents of being ATM. Let’s assume an investor purchases a call option with a strike price of $20.50 and the underlying stock price is trading at $20. In this case, the call option is near the money.
Options Trading Strategies
Traders should not get bogged down with the many and various names of options strategies. The critical thing to remember is that a plan should work for the environment you are in – bear market or bullish – to better strategize the risks of the stock price movement.
The butterfly options strategy is a classic favorite at Simpler Trading. The ability to establish multiple strike targets streamlines the risk-to-reward process. But, what is a butterfly strategy? A butterfly is a neutral, multi-leg setup that combines bullish and bearish spreads to break it down. These are just some terms and characteristics. Below are what butterfly traders may see:
- Butterfly Options Strategy – Simple Butterfly Options spreads use three different option strike prices, all within the same expiration date, and can be created using calls or puts. A typical butterfly is when traders buy one in-the-money call, sell two at-the-money calls, and buy one out-of-the-money call. The upper and lower strike prices are equal distances from the middle, or at-the-money, strike price. A butterfly spread options strategy uses four options contracts with the same expiration but three different strike prices to create a range where the method can profit.
- Iron Butterfly Options Strategy – The Iron Butterfly spread is best suited for lower volatility markets. This spread consists of four stock options trades instead of three. The setup is created by buying an out-of-the-money put option with a lower strike price, writing an at-the-money put option, writing an at-the-money call option, and buying an out-of-the-money call option with a higher strike price. The maximum profit occurs if the underlying price stays at the middle strike price.
- Reverse Iron Butterfly Options Strategy – This advanced spread is created by writing an out-of-the-money put at a lower strike price, buying an at-the-money put, buying an at-the-money call, and writing an out-of-the-money call at a higher strike price. This trade is better suited for high-volatility markets. Maximum profit occurs when the underlying price moves above or below the upper or lower strike prices.
- Broken Wing Butterfly Options Strategy – This is an advanced spread with risk inclined to one side. The spread transfers all the risk in one direction rather than equal risk covering price movement. This setup is a higher risk for maximum loss should the price direction change. Traders are rewarded with a higher profit when the stock goes in the projected direction.
- Long Call Butterfly Options Strategy – The spread is created when traders buy one in-the-money call option with a low strike price, write two at-the-money call options, and buy one out-of-the-money call option with a higher strike price. The maximum profit is made if the underlying price at expiration is the same as the written calls. The max profit equals the written option’s strike, less the lower call’s strike, and the premiums and fees.
- Long Put Butterfly Options Strategy – This advanced spread buys one put with a lower strike price, sells two at-the-money puts, and buys a put with a higher strike price. Like the long call butterfly, this position has a maximum profit when the underlying price stays at the strike price of the middle options. The maximum profit equals the higher strike price minus the strike of the sold put less the premium and fees. The maximum loss is limited to the initial premiums and fees.
- Double Iron Butterfly Options Strategy – This advanced credit neutral (market) options strategy is the combination of two Iron Butterfly spreads. Iron Butterfly spreads maximum target profitability around a single price point with a favorable risk-to-reward ratio and higher potential gain. When two Iron Butterfly Spreads are put together, a Double Iron Butterfly Spread is formed. The Iron Butterfly Spread’s maximum profit range allows spread traders to target two different profit price points.
These may sound complex, but traders first master the basic butterfly strategy that underlies the multi-leg options strategy before adding other techniques. See below, Henry Gambell going over the butterfly strategy.
Video Guide to the Butterfly Strategy
Tools of the Trade
Options traders track securities in the market just as other traders. Charting software displays technical indicators that help traders predict upcoming market trends and price changes. Technical analysis is fueled by calculated formulas that consider factors like the price or volume of an option.
Traders can use strategies in various combinations and customize indicators based on preference. Some traders follow a single indicator, while others who are more experienced may use an intricate, overlapping web of indicators.
More complex options strategies use a combination of purchasing puts and calls to maximize possible profits while buffering losses. These combinations can lessen the risk by hedging against a price that moves against the expected position.
Options trading strategies offer many advantages as they allow traders to buy, sell, or hedge on market moves. Traders often base their approach on their risk tolerance. While the market may be rough, risky, and sometimes unyielding, traders can enhance their strategies and techniques when they join a trading community.
Here at Simpler Trading, we can offer a trading community with our Options Gold membership. Traders from all over come together and trade alongside a professional trader. Sign up today and gain access to the live trading room, get trade alerts, and get answers to all your questions. Why trade alone, when you can trade with us.
FAQs on Options Terms
Q: What is the difference between purchasing a stock and buying an option of that stock?
A: Traders who purchase the option to buy a stock are only purchasing the options contract that is based on the upward or downward movement of the stock – not the stock itself.
Q: I’ve been practicing trading options on a trading platform. How can I mentally prepare myself to trade in the real market?
A: Traders who trade in a community of traders or follow mentors have more successes than those who go it alone. To better prepare to trade, options traders regularly follow trading educational guides and the market direction, and they monitor the media for essential companies or economic events. Even with all of the foresight and education in the world, the trader’s mind is often where the real battle for being prepared is won.
Q: Does trading options work?
A: The realistic answer is yes. Trading options can be a successful method. There are thousands of traders making weekly income trading options and just as many adding funds to their retirement accounts trading options. But, trading options require work and time spent studying the markets. Trading is challenging, and traders need to be committed to applying strategies and setups that have been tested and of which they have a good understanding.
Q: The market is bearish and uncertain. Should I wait to trade options?
A: Without question, we’ve had market insanity. Traders who worry about what the market should be doing are wasting time and energy. More benefit comes from following the price action and utilizing tools to extract money from the markets. Traders want to recognize when a stock is extended or recognize when the odds of a pull-back. But, we also don’t want to fight the tape. If the current market environment continues, the question becomes, “Is this something that we can prepare for, and how do we do that?”
Q: Are there an unlimited number of options contracts available?
A: Trading options is a zero-sum game because there are people on the other side of that trade. As traders move forward in the markets, if you’re making money, it’s because someone else is losing money. Why wouldn’t you want the best edge that you can give yourself? Find a Simpler Trading mentor today.