Strike Price The strike price indicates the predetermined price at which an option can be bought or sold when it's exercised. It refers to a future date. In contrast, spot price refers to the current market price of an asset. Again, the strike price is the predetermined price at which the underlying asset can be bought or sold when exercising an options contract. It plays a crucial role in option trading as it determines the potential profitability of the trade. If the strike price is set lower than the current market price for a call option, it enables the option holder to buy the underlying asset at a lower price, potentially leading to a profit. On the other hand, if the strike price is set higher than the current market price for a put option, it allows the option holder to sell the underlying asset at a higher price, again potentially resulting in a profit. Therefore, the strike price influences the decision to exercise an option and impacts the profitability of the trade.
Investors who are bullish will want to buy a call or sell a put. (Write yourself an explanation for why this is.) When options trading, buying a call means purchasing the right, but not the obligation, to buy the underlying asset at a specific price (strike price) before a certain date (expiration date). (In your own words, buying a call means "buying the right [for you] to buy an asset.") This strategy is typically used when the trader expects the price of the underlying asset to increase. On the other hand, selling a put means selling the right, but not the obligation, to sell the underlying asset at a specific price (strike price) before a certain date (expiration date). (In your own words, selling a put means "selling the right [for someone else] to sell an asset.") This strategy is typically used when the trader expects the price of the underlying asset to remain stable or increase slightly. By selling a put, the trader receives a premium upfront and is obligated to buy the underlying asset if the option buyer decides to exercise their right to sell. Investors who are bearish will want to buy a put or sell a call. (Write yourself an explanation for why this is.) Buying a put refers to purchasing a type of options contract that gives the buyer the right, but not the obligation, to sell a specific asset at a predetermined price within a specified timeframe. (In your own words, buying a put means "buying the right [for you] to sell an asset.") This strategy is often used as a form of insurance against a decline in the market price of the underlying asset. On the other hand, selling a call refers to the act of writing or selling a call options contract. In this case, the seller grants the buyer the right, but not the obligation, to purchase a specific asset at a predetermined price within a specified timeframe. (In your own words, selling a put means "selling the right [for someone else] to buy an asset.") The seller receives a premium upfront and hopes that the price of the underlying asset will not exceed the strike price, thus allowing them to keep the premium without having to deliver the asset. This strategy is often used when the seller believes the price of the underlying asset will not significantly increase.
More about Vega... Again, in simple terms, Vega measures the sensitivity of an option's price to changes in volatility. Just like how a speedometer measures the speed of a car, Vega tells how much an option's price will change in response to fluctuations in volatility. Obviously, Vega is not going to be the same for all options. It differs depending on factors like the time to expiration and the strike price of the option. This means that different options will have different levels of sensitivity to changes in volatility. Understanding Vega is allows you to gauge how much an option's price will move when volatility shifts, giving you an edge in making profitable trading decisions. To calculate Vega, you'll need to use an options pricing model, such as the Black-Scholes model. These models take various factors into account, such as the underlying asset price, strike price, time to expiration, risk-free interest rate, and of course, volatility. Once you input these variables into the options pricing model, it will give you the option's theoretical value. Then, you can calculate Vega by taking the derivative of the option's theoretical value with respect to volatility. This will provide you with a numeric value that represents the option's sensitivity to changes in volatility. There are plenty of online calculators and software tools available that can do the heavy lifting for you. All you need to do is input the necessary variables, and voila! Vega is at your fingertips. Vega plays a crucial role during periods of volatility swings, as it can significantly impact the value of an option. During low volatility environments, options with higher Vega tend to be more valuable. This is because an increase in volatility can lead to larger price movements, increasing the potential for profit from the option. Conversely, during high volatility periods, options with lower Vega might be preferred. This is because higher volatility has already been priced in, and any further changes may have a lesser impact on the option's value. Understanding Vega and its behavior during volatility swings is key to successful option trading. It allows you to make informed decisions and adjust your strategies accordingly. TIPS: Tip #1 - Keep an eye on implied volatility. The market is always buzzing with whispers about the next big move. By monitoring implied volatility, you can get a sense of what the options are pricing in. This can help you assess whether Vega is on your side or eating away at your potential profits. Tip #2 - Diversify your options portfolio. Just like a well-balanced diet, a well-balanced options portfolio can work wonders. By spreading your bets across different options with varying Vega values, you can mitigate the impact of volatility swings on your overall position. Tip #3 - Don't be afraid to adjust. Option prices are like waves – they ebb and flow. So, don't stick to a stagnant strategy. If Vega is swinging in your favor, consider taking profits or adjusting your position. And if Vega is being a sourpuss, be open to cutting your losses or finding alternative strategies. These tips will give you an edge when it comes to using Vega to your advantage during volatility swings. So, get ready to ride the waves and make calculated moves like a boss!
To get a firm handle on each of the above four scenarios, rewrite basic descriptions of them in your own words using resources like this article from Investopedia... A Beginner’s Guide to Call Buying By Alan Farley Updated April 22, 2022 Reviewed by Samantha Silbertein Fact checked by Vikki Velasquez The popular misconception that 90% of all options "expire worthless" frightens investors into mistakenly believing that if they buy options, they will lose money 90% of the time. But in actuality, the Cboe Global Markets (Cboe) and the Options Clearing Corporation (OCC) estimate that as of their research, only about 23% of options expire worthless, while 7% are exercised and the majority, just under 70% are traded out or closed by creating an offsetting position.1 KEY TAKEAWAYS Buying calls and then selling or exercising them for a profit can be an excellent way to increase your portfolio’s performance. Investors often buy calls when they are bullish on a stock or other security because it affords them leverage. Call options help reduce the maximum loss that an investment may incur, unlike stocks, where the entire value of the investment may be lost if the stock price drops to zero. Call-Buying Strategy When you buy a call, you pay the option premium in exchange for the right to buy shares at a fixed price (strike price) on or before a certain date (expiration). Investors most often buy calls when they are bullish on a stock or other security because it offers leverage. For example, assume ABC Co. trades for $50. A one-month at-the-money call option on the stock costs $3. Would you rather buy 100 shares of ABC for $5,000 or one call option for $300 ($3 × 100 shares), with the payoff being dependent on the stock's closing price one month from now? Consider the graphic illustration of the two different scenarios below. As you can see, the payoff for each investment is different. While buying the stock will require an investment of $5,000, you can control an equal number of shares for just $300 by buying a call option. Also, note that the breakeven price on the stock trade is $50 per share, while the breakeven price on the option trade is $53 per share (not factoring in commissions or fees). While both investments have unlimited upside potential in the month following their purchase, the potential loss scenarios are vastly different. Case in point: While the biggest potential loss on the option is $300, the loss on the stock purchase can be the entire $5,000 initial investment, should the share price plummet to zero. Closing the Position Investors may close out their call positions by selling them back to the market or having them exercised, in which case they must deliver cash to the counterparties who sold them the calls (and receive the shares in exchange). Continuing with our example, let’s assume that the stock was trading at $55 near the one-month expiration. Under this set of circumstances, you could sell your call for approximately $500 ($5 × 100 shares), which would give you a net profit of $200 ($500 minus the $300 premium). Alternatively, you could have the call exercised; in that case, you would be compelled to pay $5,000 ($50 × 100 shares), and the counterparty who sold you the call would deliver the shares. With this approach, the profit would also be $200 ($5,500 - $5,000 - $300 = $200). Note that the payoff from exercising or selling the call is an identical net profit of $200. Call Option Considerations Buying calls entails more decisions compared with buying the underlying stock. Assuming that you have decided on the stock on which to buy calls, here are some factors that need to be taken into consideration: Amount of premium outlay: This is the first step in the process. In most cases, an investor would rather buy a call than the underlying stock because of the significantly lower cash outlay for the call. Continuing with the above example, if you have $1,500 to invest, then you would only be able to buy 30 ABC Co. shares at its current stock price of $50. But based on the one-month call price of $3, you would be able to buy five contracts (since each contract controls 100 shares, and would thus cost $300), which means you have the right—but not the obligation—to buy 500 shares at $50. Strike price: This is one of the two key option variables that need to be decided, the other being time to expiration. The strike price has a big impact on the outcome of your option trade, so you need to do some research on picking the right strike price. For a call option, the general rule is that the lower the strike price, the higher the call premium (because you obtain the right to buy the underlying stock at a lower price). The more out of the money the call, the lower the call premium. In this case, the strike price is at the money (i.e., it is equal to the stock’s current price of $50). Time to expiration: This is another key variable. For options, all else being equal, the longer the time to expiration, the higher the option premium. Deciding on the time to expiration involves a tradeoff between time and cost. Option contracts typically expire on the third Friday of each month. Number of option contracts: Once the strike price and the time to expiration have been finalized, you will have an idea of the call premium. With $1,500 to invest, and with each one-month $50 call option costing $300, you have to decide whether to buy five contracts for the full amount that you have available to invest, or buy three or four contracts and keep some cash in reserve. Type of option order: As a derivative of stock prices, option prices can be quite volatile. You would need to decide whether you should place a market order or a limit order for your calls. What is the most I can lose by buying a call option? For a call buyer, the maximum loss is equal to the premium paid for the call. What are the drawbacks of buying call options? One drawback is that you have to get both key variables—the strike price and the time to expiration—right. If the underlying stock never trades higher than your strike price before expiration, or if it trades higher than the strike price but only after option expiry, then the call would expire "worthless." Another disadvantage of buying options—whether calls or puts—is that they lose value over time due to the expiration date, a phenomenon known as time decay. Is it advisable to exercise my call option if it is in the money and there are a few weeks remaining for expiration? In most cases, no, it would be inadvisable to do so. Early exercise would result in the investor being unable to capture the call option’s time value, resulting in a lower gain than if the call option were sold. Early exercise only makes sense in specific instances, such as if the option is deeply in the money and is near expiration, since time value would be negligible in this case. Should I buy a call option on a very volatile stock if I am bullish on its long-term prospects? Your call option might be quite expensive if the stock is very volatile. In addition, you run the risk of the call expiring unexercised if the stock does not trade above the strike price. If you are bullish on its long-term prospects, you might be better off buying the stock rather than buying a call option on it. The Bottom Line Trading calls can be an effective way of increasing exposure to stocks or other securities, without tying up a lot of funds. Such calls are used extensively by funds and large investors, allowing both to control large amounts of shares with relatively little capital.
I only saw two books at the local library on the topic of trading options. The first was Make Money Trading Options, by Michael Sincere, but as it tuned out, the book had relatively little (it seemed to me) to say on the topic. It was mostly about trading (stocks) in general and didn’t really get into options until page 169 of a total 217 pages. It starts out with about three dozen basic principles to follow which are more-or-less common knowledge, so I'll spend a paragraph or two (in a subsequent post) pointing out why I found them of little concern in order for me to highlight (in red) for myself the (two?) I felt were worth noting. Then I'll skip to page 172 to continue familiarizing myself with important concepts. At that point, I'll also open the second book, Options Trading for Dummies by Joe Duarte, which is the later edition of a book I checked out a while back, and actually offers useful details on the subject. But, I'll get an early start here by clearing this up in my mind (IF what I'm about to write is actually correct)... The premium is the price one pays for a given option; whereas the strike price is the price of the underlying stock that corresponds to a particular option. (I have to always be clear on the fact that when trading options, I am not purchasing stocks, but rather, I am purchasing contracts.)
I didn't regard most of the 39 mistakes Michael Sincere listed in his (second?) book on trading options as an issue because… I don't trade unless I've planned a strategy. I pay attention to how much money I invest in each trade. I don't gamble (unless I'm trading my Nadex demo account). I trade based on my own ideas—not on those offered by television, the Internet or friends (or even contributors to ET). My decisions are based on the numbers—on logical reasoning—rather than greed. Because my system is now fully developed and because I trade based on logical reasoning, there is absolutely no reason whatsoever for me to ever overtrade anymore. I typically trade only one or two positions at a time (or three at the most). I trade small (in my live accounts). I regularly pocket my gains so that winners don't become losers. I never place market orders (when trading stocks). I don't take phone calls or messages when trading (unless I'm mentoring someone or working on a journal). I wait until the dust settles before entering positions around economic announcements. I don't get upset or emotional if I happen to make a mistake. I simply take it on the chin and move on. I'm currently in the process of getting an options education before trading options. I've sufficiently (if not thoroughly) evaluated market indicators and charts. I've kept (and still keep) journals noting my mistakes and what I've learned. I don't add to my winners, so adding late is not a problem. I am familiar with basic technical analysis. I keep regular, if not constant, track of my positions. I cut my losses when the numbers tell me to do so. Because my decisions are based on my forecast models, chasing after stocks or any other type of asset is not a problem. Before I begin trading options, I plan on understanding how implied volatility affects option prices (in part, to avoid overpaying for options). I never double down on losing positions. (If I have reason to believe that an asset which has turned against me will eventually turn back in my favor, I go ahead and exit the position anyway and simply wait until it actually does so—if ever—before I re-enter the trade.) I don't have any physical reactions that need my attention (such as feeling sick, dizzy or unable to fall asleep). I don’t trade with money I cannot afford to lose. (My list did not come to 39 because a number of the mistakes Sincere mentioned were kind of redundant.)
IMPLIED VOLATILITY (IV) . These books and resources are telling me how implied volatility is INTERPRETED, but none of them is telling me what implied volatility actually IS. So, let me ask Google and see what I get... The Options Playbook: Implied volatility is expressed as a percentage of the stock price, indicating a one standard deviation move over the course of a year. For those of you who snoozed through Statistics 101, a stock should end up within one standard deviation of its original price 68% of the time during the upcoming 12 months. (Sincere writes that implied volatility is displayed as a percentage on the option quote in the option chain, so I'm going to need to find an image of an option chain later on today that's big enough for me to actually SEE so that I can take a look.) From page 127 in Options Trading for Dummies... . In terms of trading and IV, a general rule to keep in mind is that high readings of IV, as measured by a stock's 52-week high-low range of IV, correctly predict large future price movements, and low IV, as measured by a stock's 52-week high-low range of IV, correctly predicts small future price movements in most cases. At the same time periods of low implied volatility, when combined with technical analysis and event timing, can offer excellent entry points into options, whereas extended periods of high volatility can often offer excellent exit points. A volatility of 30 percent for a stock priced at $100 means that you may see the price of the stock to trade between $70 and $130 over the next year. The actual price movement is dependent on one standard deviation of the stock's price, which when normally distributed is 68.2 percent. So then, I take it that implied volatility is the reason why Sincere says "when the underlying stock or index goes up in price, the call option usually follows in the same direction." [emphasis is my own] It's because implied volatility can keep this from happening. For example, if implied volatility increases because of an upcoming economic event, and then decreases after the event is over, the price of an option might come down even though the price of the stock went up. Not understanding implied volatility can cause traders grief if they overpay for and option due to not being aware that implied volatility has skyrocketed. If implied volatility declines after an event is over, so does the option premium. So then, one can actually lose money on a trade even though an option is in the money and moving in the right direction.
Options Trading for Dummies said Investopedia offers an option trading simulator, so I registered there, but where's the Greek, and where is implied volatility?