Options Trading Made Easy
Long options are better in the sense that they allow us to risk a small amount to make a good profit. Whereas short options have chances of low profits.
Option contract prices are determined using the Black-Scholes pricing model for a time, volatility, and the distance from the strike price.
The most liquid options are those with strike prices that are close to the money. Options give us a greater chance for profitability as a trader because we aren’t betting on just one direction. Unlike stocks and commodities, options offer a variety of ways to structure trades and bets on volatility, ranges, trends, or lack of a trend.
Profitability comes from limiting losses whether a trader is long or short.
Stock Options as Trading Tools
There are mixed opinions on options. Some believe that they are to be avoided because one can lose more than their account is worth it. However, on the other side, they offer tremendous returns on investment, especially on the money options. Nevertheless, options traders must understand that it’s their position size and their system’s winning percentage that will determine their profitability.
One needs to manage risk properly to not lose the profits they incurred. Traders need to be fast in making decisions as it’s not like the stock market and they need to factor in the time horizon and the price direction to make profitable trades.
They are a great way of making profits fast, however, one needs to know when to limit their losses or they might blow up their account and end up getting into debt. One needs to do thorough research and not make decisions on whims otherwise they may end up losing more than they own. They are for hedging against risk, insuring losses, replacement of margin, and putting the odds in one’s favour and not gambling.
How to Increase Your Options
Options can control large blocks of stocks with call options that are going up with a small amount of capital. They can also short stocks with put options so you don’t have to find shares to borrow or use margin to sell short. Sell options short to other traders. Buy a hedge using put options to protect your long-term stock holdings. from a downtrend instead of selling your stock holdings. Manage your risk with predefined maximum capital at risk, limited to the price of the option contract. Buy or sell time value. Buy and sell volatility. Bet on a stronger trend than the market is pricing in, but bet on both directions at the same time. Create synthetic stock positions using options with little capital outlay (Selling a put and buying a call option, or the reverse). Sell an option and hedge it with a cheaper option so your short doesn’t have too much risk. Traders should watch out for Watch Bid/Ask spreads carefully and don’t trade options that are 10% apart. If you bet on a strike price and the stock doesn’t make it, you could lose what you bet and end up at zero. They are only worth the intrinsic value of the underlying stock at the time of expiration and nothing else. The time to be profitable with options is limited, so you must know when to take your profits off the table.
How Stock Options Are Priced
Understanding how options are priced are of the utmost importance when trading in options. Not having a basic understanding of their pricing could lead to hefty losses. Options contracts are priced based on the Black-Scholes pricing model to determine their value at any given time. Options are priced based on the value of the time left before expiration, and the current assets volatility or expectation of volatility due to an upcoming event, like earnings or an important report. Options will go up as the probabilities of them expiring in the money increase and will go down as the probabilities of them expiring in the money decreases. As options get closer to being in the money, they capture more of their underlying assets move, and as they get farther away from being in the money, they capture less of their underlying assets move.
The Greeks
An option's price can be influenced by several factors that can either help or hurt traders depending on the type of positions they have taken. Successful traders understand the factors that influence options pricing, which include the so-called "Greeks"—a set of risk measures so named after the Greek letters that denote them, which indicate how sensitive an option is to time-value decay, changes in implied volatility, and movements in the price its underlying security.
These primary Greek risk measures are known as an option's theta, vega, delta, gamma, and Rho. Theta measures the rate of decline in the price of an option due to time passing. Delta is a measure of the change in an option's price or premium resulting from a change in the underlying asset, while theta measures its price decay as time passes. Gamma measures delta's rate of change over time, as well as the rate of change in the underlying asset. Gamma helps forecast price moves in the underlying asset. Vega measures the risk of changes in implied volatility or the forward-looking expected volatility of the underlying asset price. Rho measures the sensitivity of a stock option’s price to a change in interest rates.
Common Mistakes Option Traders Make
Buying OTM calls outright is one of the hardest ways to make money consistently in options trading. OTM call options are appealing to new options traders because they are cheap. It seems like a good place to start: Buy a cheap call option and see if you can pick a winner. Buying calls may feel safe because it matches the pattern you’re used to following as an equity trader: buy low and try to sell high. But if you limit yourself to only this strategy, you may lose money consistently.
Most beginners misuse the leverage factor option contracts offer, not realizing how much risk they’re taking. Often, they are drawn to buying short-term calls.
Liquidity is all about how quickly a trader can buy or sell something without causing a significant price movement. A liquid market is one with ready, active buyers, and sellers always.
Don’t risk more than you would when trading stocks. He advises never to risk more than 1% of trading capital on any one trade, and the same applies to options.
Not all events in the markets are foreseeable, but there are two crucial events to keep track of when trading options: earnings and dividends dates for your underlying stock. Avoid the temptation of selling puts on junk stocks and calls on monster stocks in strong trends because this can be very dangerous
Risk Management with Stock Options
An option seller who sells a naked option with no hedge has unlimited risk exposure. One way to cap the risk on the short side of options is to buy a farther out strike option hedge for their short options, or sell options against a stock position that they have, such as a covered call or a covered put. He recommends only selling options with a hedge in place so your worst-case scenario is a manageable loss and not financial ruin.
An important lesson for new option traders is that an option can be traded at any time before expiration to be profitable; you don’t have to make a trade until expiration to make money. I think this is the safest way to sell option premium. It can be difficult to exit the long option hedge side of your trade if your short side is profitable because the liquidity will dry up on options so far out of the money. Sometimes, the hedge will be a full loss if your short side is profitable.
Buying put options solve two problems for stock traders that want to short a stock: you don’t have to worry about finding shares to borrow for a short sell, but you must make sure the put options are liquid for your time frame, and your loss is limited to the put option contract. Your long-put options can also go up in value if the volatility of the underlying stock increases because the Vega value will increase.
The Truth About Weekly Options
Weekly options are similar to monthly options, except they expire every Thursday instead of the fourth Thursday of each month. They have very high Deltas and most of them are very liquid. They are ideal for traders that are trading on a daily or weekly time frame with entries and exits in their pre-existing stock trading system. Weekly options are good for risk management on the long side if traded within the money options as a replacement for stock. They can give a trader access to control large blocks of stock for minimal capital used on a short time frame.
The author instructs us to buy them in the money to capture directional trends. If you want to sell them for premium, it’s best to sell both the call and put at the money and then hedge by buying farther out of the money call and puts on each side.
Weekly options should only be traded with the same position size you would use while trading the underlying stock. Using in the money options gives you better odds of success because you only pick the direction of the move. While weekly options provide great asymmetric trades with an unlimited upside and limited downside, there is still capital at risk and you should be careful not to make a large trade with weeklies because you are overconfident.
How Not to Use Options
One of the most dangerous ways to use options is to sell covered calls. Selling covered calls in a bull market also cap your uptrend gains for a small fee. In a bear market, covered calls are shifting all the big downside risk to the person holding the underlying stock, and giving the possible upside to the call buyer for a small fee. In a bull market, a covered call is a “stop gain”, where you will miss out on big trends because you sold the trend above your covered call strike price for a small fee.
Does Selling Options Premium Give You an Edge?
Most losing short side option trades are closed before expiration for a loss to stop the risk exposure of a short contract that is going in the money. Option sellers could be closing their short options trades before expiration to cut their losses short. The question about what side of an options trade is the most profitable, the short or the long side, can’t be answered by how they expired in or out of the money, but how options traded over the full life of the contract.
Options are a zero-sum game; for every long, there is a short. For every option profit, there is an option loss. Options are fungible and interchangeable, so they are traded back and forth as they march toward expiration. Options will change hands many times before expiration, and these trades are where option buyers can profit before their time runs outs. Options can be traded profitably from the long side by taking the profits while they are there. Option profits are not just determined at expiration but are determined as they occur every day. Option premium sellers can be hurt during trends. The risk and probabilities play out evenly over the long run, with option sellers collecting many small wins and some big losses, and the option buyers having many small losses and some big wins. The winners are not exclusively on the long or short side, they are options traders with an edge, risk management, and discipline.
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