An option is a legal agreement between a buyer and a seller to purchase or sell securities at a certain price within a specified time frame. It is similar to insurance in that you pay a fee in order for the insurance provider to safeguard your property. The distinction between these two is that options may be exchanged, but insurance policies cannot. Call options and put options are the two forms of options contracts. We buy call options when we believe the security price will rise and put options when we believe the security price will fall. We can also sell call options if we believe the security's price will fall, and vice versa if we sell put options. Typically, options are counted per contract, with one contract equaling 100 unit options. 1 unit option safeguards 1 unit share. As a result, a single contract protects 100 unit shares.
Before understanding Stock Options Trading, you need to be familiar with the following terms:
a) Strike price: The strike price is the price agreed upon by both the buyer and seller of the option to trade. That instance, if the striking price of the call option is 35, the seller of the option is obligated to sell the security to the buyer of the option at that amount, even if the market price of the security is higher if the buyer exercises the option. This option allows the buyer to purchase a security at a cheaper price than the market price. The buyer will get $4 if the current market price is $39 If the security price is less than the strike price, the buyer will keep the option and allow it to expire worthlessly. The buyer of a put option has the right to sell the security to the seller of the option at the strike price. That instance, if the put option strike price is 30, the seller is obligated to buy the security at this price from the buyer if the option is exercised, even if the market price is lower. If the market price is $25, the option buyer will profit by $5. It appears that many transactions have occurred; nevertheless, the seller of the option will not purchase a security and then sell it to the buyer. The broker business will handle the whole transaction, but the seller is responsible for any additional funds spent to purchase the security. This indicates that if the seller loses $4, the buyer gains $4.
b) Out-of-the-money, in-the-money, and near/at-the-money options: Option prices include time value and intrinsic price.
Option Price = Time Value + Intrinsic Value
The time value of an option is the amount of money it is worth because of how much time it has until it expires. The longer the option has until its expiration date, the higher its time value. If an option has expired, its time value becomes zero. The difference between the current market security price and the option strike price determines the intrinsic value of an in-the-money call option. In contrast, the intrinsic value of an in-the-money put option is the difference between the option strike price and the current market security price. This option is out of the money if the current security price is less than the strike price of the call option. It solely has a monetary worth. An in-the-money option is a call option with a strike price lower than the current market security price. This choice has both time and intrinsic value. The near or at-the-money option has a strike price that is close to the current market security price.
c) Delta value: The delta value indicates how much the option price increases when the security price changes by $1.00. It is good for call options and negative for put options. Its value varies from 0.1 to 1.0. The delta value for the in-the-money option is greater than 0.5, while the delta value for the out-of-the-money option is less than 0.5. The delta value for a deep-in-the-money option is often more than 0.9. If the option delta value is 0.6, this means that when the security price rises by $1, the option price rises by $0.60. If the security price rises by $0.10, so will the option price. Normally, $0.06 will be rounded up to $0.10.
d) Theta value: A negative value that represents the decline of the option time value. The absolute theta value of an option with a longer time to expiry is lower than the absolute theta value of an option with a shorter time to expiry. The option with a high absolute theta value decays faster than the option with a low absolute theta value. A theta value of -0.0188 indicates that the option will lose $0.0188 in premium after seven days. Options with a low absolute theta value are preferable to those with a high absolute theta value for purchasing.
e) Gamma value: The change in the delta value of an option when the security price increases or lowers is shown by the gamma value. For example, a gamma value of 0.03 means that when the security price rises by $1, the delta value of this option will rise by 0.03. The option with a longer time to expiry has a lower gamma value than the option with a shorter time to expiry. When the security price approaches the option strike price, the gamma value changes considerably.
f) Vega value: The Vega value is the change in option value for every one percent increase in implied volatility. This is always a positive value. The near-money option has a larger vega value than the in-money and out-of-money options. The option with the longer expiry period has a greater vega value than the option with the shorter expiry time. Because vega value gauges the option's sensitivity to changes in security volatility, greater vega value options are desirable for purchase over those with low vega value.
g) Implied volatility: Implied volatility is a theoretical figure used to reflect the volatility of the price of a security. It is determined by entering the Black-Scholes equation with the actual option price, security price, option strike price, and options expiry date. Stock options with high volatility cost more than those with low volatility. This is due to the increased likelihood of a high-volatility stock option becoming in the money before its expiration date. The majority of buyers choose high-volatility stock options over low-volatility stock options.
Actually, the majority of options investors and traders employ twenty-one option trading techniques in their everyday trading. However, I will just present ten techniques, as follows:
a) Uncovered call or put
a) Put or call spread
c) Straddling
d) Suffocate
f) Covered call
f) Necktie
Condor (g)
h) Combination
I Butterfly swarm
j) Spread of the calendar
Naked call and put options are those that are purchased just at the strike price, which is close to the market security price. When the security price rises, the profit is calculated by subtracting the security price from the strike price if you buy a call and the opposite if you buy a put.
A call-and-put spread is formed by purchasing an option in the money or near the money and selling an option out of the money. When the price of the security rises, the in-the-money call option you buy will benefit, while the out-of-the-money option you sell will lose money. However, because of the delta value difference, as the security price rises, the in-the-money call option price rises at a faster pace than the out-of-the-money call option. You still make money after deducting the profit from the loss. The goal of selling the out-of-the-money option is to safeguard against the depreciation of the time value of the in-the-money call option if the security price falls. However, if the security price continues to fall, the loss will be infinite. As a result, the stop loss must be set at a certain level. This technique also has a maximum profit, which occurs when the security price crosses over the in-the-money option strike price.
Straddles can profit whether the security price rises or falls. This strategy is built by purchasing near-money calls and putting options with the same strike price. The downside of this technique is that it has a high breakeven point. The total of the call and put option ask prices is the strategy's breakeven point. Profit is generated only when the security price has moved above or below the breakeven point. You will still lose money if the security price varies between the upside and downside breakeven levels. The money you lose is due to the option time value deterioration. This method is typically used for volatile securities or before the release of earnings reports. The combined sum of the call and the put option price is the strategy's maximum loss. This method has the potential to create endless profits on either side of the market.
Strangle and straddle are synonyms. The distinction is that a strangle is formed by purchasing out-of-the-money call and put options. Because both alternatives are out of money, they have different strikes. This strategy has a lower maximum loss than the straddle strategy, but the gap between the upside and downside breakeven levels is significantly bigger. The upward breakeven for this strategy is computed by adding the entire call and put option prices to the call option strike price. The downside breakeven level, on the other hand, is derived by subtracting the put option strike price from the combined call and put option prices. Depending on the stock you choose to buy with this approach, the difference between the strike prices is normally around 2.50 or 5. Even if the security price varies within the breakeven range, you will still lose money owing to the loss of the option time value. This method is used in the same way as the straddle strategy.
A covered call is formed by purchasing a securities at its current market ask price and selling an out-of-the-money call option. The possibility of selling out of the money has restricted the profit made by this technique. If the value of the security continues to fall, the loss will be infinite. As a result, a stop loss must be established. If the security price does not considerably rise before the option expires, you will still get the whole option premium that you have earned. Sure, you'll make a small profit if the security price rises. If the stock price continues to fall, the loss will be infinite. As a result, a stop loss must be established. Typically, the stop loss is set at the security ask price less the option bid price. If the price of this asset falls and crosses over the price that you selected as your stop loss, you will incur a loss equal to about half of the entire option premium that you have received. This is because the delta value of the out-of-the-money call option you sold is between 0.4 and 0.5. The out-of-the-money call option strike price must be the same as the entering security price.
The collar is another term for the medium-covered call. It's quite similar to the covered call technique. It is merely one more step added to ensure that a stop loss is not required in this technique. This strategy is constructed by purchasing security and a near-money put option, followed by the sale of an out-of-the-money option. Because you purchased a put option, it is unnecessary to set a stop loss because the put option will protect the security if the security price falls. However, the option premium money that you have gathered must be utilized to pay for the put option premium. If the security price falls, you will still lose around half of the total put option premium. This is because the premium for an out-of-the-money call option is smaller than the premium for a near-money put option. This method is intended for a one-year or half-year investment.
The Condor strategy includes four variants. Two are for the fixed market, while the other two are for the dynamic (volatile) market. Long call and put condors are used in a stationary market, while short call and put condors are used in a dynamic market. The former method consists of four steps: purchasing and selling in-the-money and out-of-the-money call options with an equal amount of contract. Profit may be created with this technique as long as the security price does not deviate from the upside and downside breakeven levels. Short call and put condor strategies are for volatile markets and, like the long call and put condor method, comprising four phases. The distinction is that the strike prices of the options purchased must be within the strike prices of the options sold in a short call and put condor. Profit can be earned using the short call and put condor technique as long as the security price has varied outside of the upside and downside breakeven levels. The upside breakeven level is computed by adding the total payout or receive for the whole position to the strategy's highest strike price. The downside breakeven level is established by subtracting the total pay or receive from the strategy's lowest strike price.
The combo approach has two combinations: bullish and bearish. The bullish combination approach is used in a bullish market, whereas the bearish combo method is used in a bearish market. This technique consists of two steps: selling out of the money option and purchasing in the money option. Profit can be made if the security price rises over the higher strike price. However, if the security price falls below the lower strike price, a loss is incurred. You will not lose anything if the security price varies between the higher and lower strike prices. This method can provide an endless profit but can also generate an unlimited loss depending on the market direction and approach applied.
The butterfly spread approach and the condor strategy are quite similar. It also offers four combinations: long at the money call and put butterfly spread, short at the money call and put butterfly spread, and long at the money call and put butterfly spread. Long at-the-money call and put butterfly spreads are used in a stationary market, while short at-the-money call and put butterfly spreads are used in a turbulent market. Buying in-the-money and out-of-the-money call options, followed by selling at the money call option, are the steps involved in a long at-the-money call butterfly spread. At the money option indicates that the strike price is very close to the current market security price. The number of contracts of at-the-money call options must be double the number of contracts of in-and-out-of-money options. Profit can be made as long as the security price does not go beyond of the breakeven zone. By adding the total payout of this position to the highest strike price, the upward breakeven level is established. Subtracting the lowest strike price from the entire payout of this trade yields the downside breakeven level. The short at the money call butterfly spread is formed by selling in and out of the money call option, then purchasing at the money call option. The number of contracts for at-the-money options must be twice the number of contracts for in-and-out-of-money options. Profit can be produced as long as the security price has moved above and below the breakeven point. This approach creates a modest profit while also causing a limited loss if the security price does not move in the desired direction.
The calendar spread is often referred to as horizontal spread or temporal spread. This method is primarily utilized to profit from the security's sideways price movement. This type of price trend may be found in a variety of equities. This strategy is developed by selling an out-of-the-money call or put option with a shorter time to expiry and purchasing an out-of-the-money call and put option with a longer time to expiry. This technique simply earns money from the option's time value. The option with the shortest time to expiry depreciates the time value more quickly than the option with the longest time to expiry. Typically, the option with the shortest time to expiry is allowed to expire worthlessly. The entire amount of money you get after closing this position will be more than the total amount of money you put out when initiating this position.
You may utilize these 10 tactics to profit from both up and down markets, as well as markets that trade sideways.
