Why We Trade Options
Option trading is quite likely the fastest growing investment venue in the world. If it isn’t, it certainly should be. There are many good reasons for its explosive popularity. First, many individual option traders earn more income from trading options than they earn from their full-time jobs. Many who retire from their job careers and learn the nuances of option trading quickly discover they can earn more income trading options by spending 1 or 2 hours a day than they did working every week day from 8:00 a.m. till 5:00 p.m. And they don’t have to make that daily round trip to the office, pay tolls and parking fees, or fight traffic. At least, that’s been my personal experience and that of many people I personally know who have learned how to earn steady incomes trading options.
And learning how to enter, manage, and close option trades for profit is not “rocket science.” It’s simple arithmetic. The beauty of options is that they are mathematically predictable. Option traders quickly learn how to use statistical probabilities to manage their trading outcomes. And their odds are much better than those of a gambling casino. Casinos thrive on 54.5 percent odds of winning over their client gamblers, who are left with 44.5 percent odds of winning. If gamblers stay at the tables long enough, they will lose their entire bankroll to the casino. But option traders learn how to structure their option trades to achieve winning odds at or even greater than 70 percent and some strategies that exceed 9.5:1 odds of winning.
Of course, before you can benefit from these impressive option trading odds, you must
- understand how options work.
- open and fund an account with a reputable brokerage.
- learn to use your brokerage’s trading software.
- develop a set of options trading rules.
- learn to use a handful of options strategies.
- apply your rules to your daily trading and options management tasks.
Option Education and Books
There are many options books you can read, but I recommend The Only Options Trading Book You’ll Ever Need. I wrote that book for people who want to learn how to analyze price charts and trade options from scratch. These people may want to supplement the income provided by their day jobs, or they may be retired, on social security, and have a stagnant 401K or individual retirement account (IRA). They would benefit from an alternate income source. Those stagnant retirement funds can be converted to rollover IRAs with any reputable brokerage and their values multiplied by trading them. Many option traders have doubled and even quadrupled the value of their qualified retirement accounts. If they can do it, you can do it too.
I wrote the above-mentioned option trading book for people who do not know how the market works but who want to learn. This is important, regardless of what kind of trader you are—from a buy-and-wish stock investor to one who invests in commodity futures. My book goes through the entire process. The following is a partial list of the topics covered:
- Choosing a brokerage
- Funds transfer
- Negotiating commissions and trading fees
- Selecting and setting up trading equipment
- Installing essential communication devices
- Developing backup systems
- Analyzing price charts
- Using chart studies to determine current supply and demand
- Understanding and using Option Chains
- Learning option math (called the Greeks)
- Understanding the impact of volatility, liquidity, and the passage of time on option values
- Developing a set of sound, fact-based option trading rules to enhance trading outcomes
- Understanding how to set up, enter, and manage a broad range of option strategies
- Learning how to measure trade probabilities
- Knowing how to manage risk
- Developing and scanning a watch list of trade candidates, that is, stocks, exchange-traded funds (ETFs), financial indexes, and futures
- Mastering the use and management of several option strategies
- Closing trades for profits
- Rolling trades up, out, and/or down
- Legging a failing trade strategy into a winning trade strategy
- Trading small brokerage accounts and rollover IRAs.
The above-mentioned topics, and many others, may seem daunting. But they are not that complex. And if you have my book, you can “own the knowledge,” because the carefully crafted glossary and alphabetical index guide you to essential information in a flash.
Option Premium—Insurance policy sellers collect premium from insurance policy buyers. Insurance companies sell their policy holders options. These premiums lose value with time and expire worthless when the insurance policy expires. But, if you suffer a loss on your insured property while the insurance policy is in force, you can “exercise your option” to collect insurance for that loss. Like the insurance policy, options are a depreciating asset. Premium value exits each and every day until the option contract expires worthless.
Just for review, a typical option chain is included on the following page.
NOTE: Delta, Gamma, Theta, Rho, and Vega (although Vega is not in the Greek alphabet) are commonly referred to as the option Greeks. These Greek values are displayed in the columns of option chains for each strike price. Experienced option traders examine these as part of their trading analysis. The Rho Greek (rate of interest) is significant only when interest rates are high, so Rho is rarely displayed for analysis purposes when interest rates are low and reasonably stable. High interest rates increase call premiums; when Rho is low, put premiums are typically higher than call premiums. Other values can also be displayed, such as Extrinsic Value, Intrinsic Value, Last, and so on. However, displaying too many columns on an option chain creates clutter and makes it difficult to read.
Premium (MARK)—Option traders search for sufficient premium values displayed in the Mark column to justify the risks involved in their trades. The Mark value is typically midway between the Bid and Ask column values. Narrow bid-to-ask widths indicate strong trading volume and liquidity. This is also reflected by each strike’s Open Interest value described in the following paragraphs. When wide, the Mark moves within a much wider price range, referred to as “slippage.”
Some consider premium values of 30 cents or higher to be acceptable, especially when an extremely high probability of success exists. When premium is insufficient, continue scanning your list of trading candidates (your watch list) and the underlying price charts. Find imbalances in supply and demand near support or resistance. Study the price trend and develop a rational trading bias. Check the implied volatility (IV percent) at the top of the option chain; the average 14-day price move, that is, the ATR(14) study; the times till expiration; and an oversold/overbought momentum study such as the moving average convergence divergence (MACD) or relative strength index (RSI). Examine the option values including the Greeks, alluded to in the following paragraphs, Open Interest, and sufficient premium to warrant each trade’s risk.
Delta—Delta and Gamma relate directly to premium values (option prices) of the underlying security; the Mark (market price) is the midpoint between the Bid and the Ask. Delta measures the option premium’s sensitivity to a $1.00 change in the value of the underlying security. Although many believe that a Delta value of 0.45 causes the premium to change by 45 cents for a $1.00 change in the underlying security, it’s more complicated. The impact of Delta on option premium values uses a complex formula with several variables, such as Lambda and Psi, which are not shown on option chains. But it’s easy to examine Delta values at different strike prices on any option chain. Delta values are positive for long calls and negative for long puts. Delta values are negative for short calls and positive for short puts. Moving from low to high strike prices, call Deltas range from 1.00 to 0.00; put Deltas range from 0.00 to −1.00.
Gamma—Gamma calculates how much the value of Delta changes for each $1.00 change in the underlying. If a 0.40 Delta of a long call has a Gamma of 0.05, a $1.00 drop in the price of the underlying security reduces the value of the call’s Delta to 0.35. A $1.00 rally in the price of the underlying security would increase the call’s Delta value from 0.40 to 0.45. Gamma is highest “at the money” (ATM) (the strike nearest the price of the underlying security—stock, ETF, and so on) and declines in value at strike prices either deeper in the money (ITM) or farther out of the money (OTM). This incrementally reduces the amount Delta changes as it moves away from “the money” in either direction. This sluggishness is an incentive to close a trade once the effect of Gamma on Delta offsets a trade’s benefit from price movement in the underlying optioned security.
Theta—Theta measures the effect of the passage of each day in time on an option’s premium (Mark) value. Theta increases as an option approaches its expiration date and ultimately reduces premium to 0 at option expiration. A Theta value of 0.05 indicates a reduction in option premium of 5 cents per share per day, or $5.00 per day per 100-share option contract. Without some unforeseen price breakout, it follows that Theta increases in value each day as an option contract approaches expiration. A high Theta value is the enemy of option buyers and the friend of option sellers. Theta can be at 0.00 for long-term (LEAPS) option trades. Having 0 to extremely low Theta values is beneficial to the buyers of LEAPS call options who favor a long-term price increase in the underlying optioned security.
Vega—This “Greek” is sensitive to trading volatility in the underlying security. Option premiums are most responsive to changes in volatility, so Vega has the most impact on option premium values. A Vega value of 0.09 causes the corresponding premium to change by 9 cents per share for each 1.0 percent change in current volatility (IV percent). Using 0.09 Vega, if a premium is presently 30 cents per share, a 3 percent rise in volatility moves the premium value from 30 cents to 57 cents per share [$0.30 + (3 × $0.09) = $0.57] per share, a rise in premium from $30 to $57 per option contract. This is a 90 percent increase in premium resulting from a 3 percent increase in volatility! (Some traders use IV Rank, which is a percentage of the past 12 months’ volatility, called “historical volatility.” While IV percent can range beyond 100 percent, IV Rank values remain between 0 and 100.
Open Interest—The Open Interest tells option traders how many option contracts are currently open at each strike price. This is a measure of option liquidity and therefore is extremely important. Insufficient liquidity makes it difficult to enter or exit an option trade. Always look for a few hundred working contracts at the strike prices of interest. Also calculate the total number of open option contracts for all calls and puts that exist on the selected option chain. Having a large number of working trades makes trade entries and exits much more responsive.
Using Risk Profiles
Every option trading platform can display a risk profile, also called a risk graph. Regardless of what we call it, the risk profile displays a graphical plot that shows traders how each option trade responds to changes in the price of the underlying security.
The following are two risk graph illustrations and a snapshot of the Probability Analysis display for the same bull put spread strategy. The bull put option strategy is described later in this book.
Figure 3 shows an option trade entered on July 28, 2017. This trade sells 10 $143 QQQ puts and buys 10 $140 QQQ puts. The order bars at the bottom of the figure show a credit of $0.75 cents per share for a total credit of $750 in option premium. Recall how the term short is used when selling and long is used when buying stocks, options, and futures. These terms are used throughout this book.
Notice the vertical dashed line at $144.11 on the X axis. This is the current price of the underlying QQQ NASDAQ 100 ETF. The gray shaded area (#1) on either side of the vertical $144.11 line represents 1 standard deviation (68.27 percent) above and below the current price of QQQ. The smooth line represents the calculated hypothetical price of the underlying equity. This plot is based on the underlying math, which in this case is based on the trending price of the QQQ ETF.
Option traders often use 1 standard deviation as a measure of probability. This value is derived from current trading volume. The math indicates that QQQ prices that exist above and below 1 standard deviation have a 67.28 percent likelihood of being OTM when the selected QQQ option contracts expire on August 18, 2017. More conservative traders move even farther OTM. For example, call Delta values at or less than 0.25 and put Delta values at or greater than −0.25 are common.
The Price Slices (#2) are used to estimate profits or losses at different prices of the underlying security. Price slices are adjustable in dollars, percentage, or by standard deviation, represented by the Greek letter σ (sigma).
The Greeks, including Delta (#3) Gamma, Theta (#4), and Vega, plus the profit or loss (P/L) Day (#5) and P/L Open, are also shown. As an options trader, you know how Theta represents the daily reduction in the value of long option premium. Delta shows us how the premium value changes relative to a $1.00 increase or decrease in the price of the optioned security—the Powershares QQQ ETF in the example.
Figure 4 illustrates how price slices (#3) can been adjusted by $2.00 above and $2.00 below the current price of QQQ—the center price slice. Vertical dashed lines that correspond to your price slice values are added to the graph. Looking across the +$2 price slice at the P/L Open (#4), a $2.00 increase in QQQ’s price returns a $749.67 profit. You can also add more price slices above and below to see the Greek and P/L values at different hypothetical price levels.
Figure 5 illustrates the Probability Analysis. The Powershares QQQ ETF prices inside the cone-shaped plot include those QQQ prices that remain within the 68.27 percent standard deviation value. Prices above and below the cone-shaped envelope have a 68.27 percent statistical probability of being OTM at contract expiration.
You can adjust the value of the Prob. range to test other values, such as 75 percent or 80 percent. You can also select 2 standard deviations (95.45 percent), which are also used by some option traders—especially on high-priced stocks and financial indexes with high option premium values. The default setting of the Prob. mode is ITM. You can change this setting to OTM or the more conservative Touching on the basis of your personal preference. The Probability of Touching values is typically within a few percentage points of being two times the value of Delta. In contrast to being OTM at expiration, the Probability of Touching value assumes that the corresponding strike price will never touch the ATM strike price throughout the duration of the trade. However, even math is never 100 percent reliable.
Trading rules are used by those who trade as a business. Without rules, it’s difficult to know why trades aren’t working, particularly if they are entered helter-skelter and are constantly failing. So, here’s a starting place:
Time—Sell options that expire inside 7 weeks (56 days). Always choose the nearest expiration date possible that is consistent with acceptable premium values. Buy options that remain in force for 90 days or more. Having more time reduces the daily reduction in option premium, measured by the value of the option Greek Theta.
Probability—When selling options to collect option premium, select strike prices that are far OTM with call Delta values of 0.25 or less and put Delta values of −0.25 or higher. (To clarify, a Delta value of −0.10 is higher than a put Delta value of −0.25.)
Volatility—Buy options when current implied volatility is low and premium values are relatively inexpensive. Sell options when volatility is high and premium values are high. Traders count on implied volatility to return to historical levels. Consider adding IV Rank to your price charts.
ATR(14) in dollars and percent—Always check the recent price movement in both dollar and percentage terms. Although useful, these values are based on history. The random nature of the market can “turn on a dime.”
Oversold/Overbought (Momentum) Studies—Check these studies for the current buying or selling momentum. Exceptionally high or low values indicate overbought or oversold, respectively. Look for all four study values to be in agreement for confidence.
Premium—An acceptable premium value depends on each trader’s personal goals and risk tolerance. How much do you want to earn? How much are you willing to risk? What must you pay in commissions and option exchange fees to make a trade worthwhile? Once you determine the answers to these questions, you may be able to select a minimum premium amount. Setting a minimum premium value simplifies trading. If your rule is a minimum of $0.30 in premium per 100-share option contract, then your trade scanning becomes easier. You can discard all trades that do not meet your minimum premium requirement within a few seconds.
Open Interest—This is a measure of liquidity. When liquidity is good, orders fill rapidly, making both entry and exit faster. As a “rule of thumb,” many traders look for Open Interest values of 300 or more at the strike price of interest. This is especially true when trading a large number of option contracts. Others settle for Open Interest values that are 10 times the number of contracts traded. Using this rule, a 5-contract order would require an Open Interest value of at least 50, (5 × 10 = 50). Always look at Open Interest values above and below on both the call and put sides of the option chain to verify ample trading volume exists on the selected option chain.
When using 3- or 4-strike option strategies, seek Open Interest of 300 or more. When using a 1- to 2- strike option strategy, 10× the number of options may work. But to be filled quickly, your premium must be fairly priced. And be mindful that it’s much more important to close a trade for profit or to prevent a loss than to open a trade for speculation. Do what is necessary to exit quickly for profit or to avoid an unwanted loss. Many seasoned traders will give up five cents in premium to fill an open order.
Risk Tolerance—How much money are you willing to lose? Each strategy has a potential risk and reward. The size of your trade governs how much money is put at risk. Many traders use the total marginable equity held in their brokerage accounts to govern the amount they’re willing to risk. For example, if they are willing to lose 1.0 percent of a $25,000 account, they would never risk more than $250 on a single trade. This illustrates how it takes money to make money. An unwillingness to lose more than $250 in a trade makes it difficult to grow an account. However, by simultaneously keeping half-a-dozen high-probability trades working, traders can ensure that their account can achieve rapid growth. And options provide traders with a number of defined-risk option strategies, such as iron condors, bull put spreads, and butterflies. These, and many others, limit the total amount of money that can possibly be lost. Others, like the synthetic long stock strategy, can return a substantial amount of money for a small investment. But, of course, the trader’s bullish bias must be correct. Be sure to study these strategies. Try them in simulation to see how they can be put to work for a steady income.
Using the Strategies
Within the 78 strategies included in the remainder of this book, the number of 100-share option contracts, designated by n, is provided in the setups for each strategy. A brief description of each follows.
Bias, Risk, Reward: Each strategy is accompanied by a trader’s bias, that is, bullish (uptrending price), bearish (downtrending price), neutral (sideways moving “stuck” price). The risk and reward indicators correspond to each strategy’s outcome potential for profits and/or losses. Many traders specialize in selling options for premium income. These are considered “low-reward” strategies, although many option traders make tens of thousands of dollars in weekly incomes by selling put and call options and vertical put and call “spreads,” such as the short put and the bull put and bull call strategies described in this book.
Price Charts: Option traders analyze price charts to determine price support and resistance levels. These correspond to demand and supply. When a stock is oversold, the price drops, which attracts buyers. When overbought, the price drops from selling activity. Therefore, be sure to examine price charts to see where the price has been and to determine what is most likely to occur relative to buying or selling.
Delta is used by option traders to gauge the statistical probability of an option price to become ITM prior to the option’s contract expiration date. Many option traders use Delta 0.25 as a 25 percent likelihood of the corresponding option’s strike price becoming ITM prior to expiration.
Implied Volatility (IV percent) is used by option traders for strategy selection. When IV percent (or IV Rank) is high, premiums are high. This encourages option traders to choose a strategy that sells premium. The seller is rewarded when the premium begins to decline in value, which permits the seller to buy to close the option contract for substantially less premium than originally received, that is, sell for a dollar, buy back for 25 cents—a profit of 75 cents per share. When IV percent is low, premiums are low. This encourages the use of option strategies that buy premium. The buyer may buy for $0.25 per share and sell for $1.00 per share—a 400 percent profit.
A glossary of option terms and definitions is included at the end of this book. If you encounter an unfamiliar term or abbreviation, be sure to check the glossary for a definition. For a complete options tutorial that takes its readers from basic concepts to advanced topics, including technical analysis, rules-based options trading, trading options on futures, trading options on small accounts, and much more, see The Only Options Trading Book You’ll Ever Need, which is available from Amazon in both paperback and Kindle formats.