Head of Product Strategy for OptionsPlay
Options trading is a skillset that typically takes a few weeks to a few months to learn. The numbers and strategies can be intimidating initially, but don’t be discouraged. If the option chains, Greeks and terminology seem complicated, let’s start with foundations.
There are 2 basic strategies that options traders should learn before they start trading: writing covered calls (income) and buying calls and puts (speculation).
Writing covered calls
Writing covered calls is an income-generating strategy used for stock or ETF holdings in an equity portfolio. This strategy requires holding at least 100 shares and writing an “out-of-the-money” (OTM) call option. An “out-of-the-money” call option is one with a strike price above the current stock price. The writer of a call option is obliged to sell his or her stock at the strike price of the call option upon expiration. The goal of this strategy is for the option to expire worthless with the stock below the strike price at expiration, thereby allowing the investor to keep the income from writing the call option. When this happens, the investor can continue writing covered calls to generate a stream of income from his/her equity portfolio through a series of expirations! In the event that the stock price is higher than the strike price upon expiration, the stock is sold to the buyer of the call option at the strike price. Here are some tips and best practices to follow to avoid the common mistakes made by beginners:
Buying calls and puts is an option strategy that is used for speculation purposes (based on a bullish or bearish view on a stock or ETF). If an investor has a bullish outlook on a stock or ETF, buying a call option can provide upside exposure. Conversely, for a bearish outlook, an investor could buy a put option to profit from a potential downside move. When buying calls or puts, it is best practice to use expirations that are at least 1-2 months from expiry and with “at-the-money” strikes (a strike price that is close to the current market price). Novice options investors tend to make certain mistakes, but following some of these tips will help you avoid them:
Understanding the Greeks
The Greeks are variables used to measure factors affecting the price of an option. At first glance, the Greeks can be intimidating to new option traders. Buying stocks is much easier to understand, due to the dollar-for-dollar exposure, but options are not as straightforward. While the Greeks are not as complicated as they may initially seem, it is important for traders to understand how they work on a conceptual level. The two most important Greeks are “Delta” and “Theta”:
- Delta – Delta refers to the rate of change in an option’s price with respect to small changes in the underlying stock price. For larger moves in the underlying stock price, an additional Greek, Gamma, needs to be considered. For example, buying a call option with a Delta of 0.5 signifies that the value of the option will increase by $0.50 if the stock moves $1 higher. Delta is calculated as follows:
Delta = Change in option price/ Change in stock price (for small changes in the price of the underlying)
- Theta – Theta refers to the rate of change in the option price with respect to time, with other factors remaining constant. As options have an expiration date, an option’s price will decay as it approaches expiration. Theta tells us the rate at which an option’s price will decay over time. When buying options, it is best practice to exit the position as quickly as possible to minimize the effect of time decay eroding your gains and magnifying your losses. Theta is calculated as follows:
Theta = Change in option price/ Change in time (when other factors such as the price of the underlying are held constant)
Using the tips and best practices mentioned above should help you understand your first options trade. While there is always more to learn, being comfortable with the basic strategies and terminology will help you acquire a solid educational foundation.