I want to preface this post by saying that I personally only trade stocks at the moment and do not have a ton of experience trading options, which is why all of my posts and education are based around stocks. With that being said, I have done my fair share of options trading in the past and definitely know enough of the basics to share for all the traders that ask me about options on a daily basis. If you already have a bit of experience with options, this post may not be very beneficial to you because I'm just going to cover the basics of options, how they work, and give a quick rundown on ways that you can trade them!
First and foremost, what are options? Options are actually... options. When you buy an option contract, you then have the option to buy or sell the underlying stock at a pre-determined price up to a pre-specified date. If you decide to do this, you are then "exercising" your options.
There are two types of options that you can trade, which are call options and put options. Call options, or just "calls," allow the holder to buy at the pre-determined price and are the options equivalent to simply buying or longing the underlying stock. Because of this, your call options' price will generally rise as the price of the underlying stock rises. Put options, or just "puts," allow the holder to sell at the pre-determined price and are the options equivalent to short-selling the underlying stock. Because of this, your put options' price will generally rise as the underlying stock declines. Because one single option contract represent 100 shares of the underlying stock, you would have 100 shares of that stock for every call contract that you exercised.
Now, the pre-determined price that you can either buy or sell you shares at by exercising your option contract(s) is known as the strike price. When buying options you have to choose a strike price, along with an expiration date, which is the last day that your options can be exercised. Both the strike price and expiration date play a big role in choosing which contracts to buy, because they greatly affect how the options will trade. Before getting into why these have such a big affect on the options, it's important to know a bit more general options information.
As for strike prices, there are really two main kinds. In The Money (ITM) and Out of The Money (OTM). ITM and OTM refer to the underlying stock's price in relation to the strike price of the contract. Calls with a strike price below the current price of the underlying stock are considered ITM, whereas calls with a strike price above the current price would be considered OTM. On the other side of the spectrum... since you want the stock's price to go down when you own puts, your put options would be ITM if the strike price is above the current stock price and OTM if the strike price is below the current stock price.
I know it's a bit confusing if you're new to options. To give an example: If stock XYZ was trading at $100, a call option with a strike price of $90 would be ITM since the underlying stock is already above the strike price. However since calls and puts are essentially opposite, a put with a strike price of $90 would be an OTM put in this scenario.
Whether an option is ITM or OTM has a big impact on how to option will trade. The main reason for this is because all OTM options are worthless at expiration. This means that if you invested $100 by buying one call option at $1.00 ($1.00 x 100), your contract would be worth $0 if it was OTM at the market's close on the expiration date and you would lose your full $100 investment. Because of this, OTM options are generally higher risk, higher reward than ITM options. Although ITM won't be worthless at expiration like OTM options, they will still lose value over time because all options are affected by time decay.
Time decay in options causes the price of the contracts, also known as the premium, to decrease as it gets closer to expiration. This alone makes being a profitable options trader much more difficult in my opinion, because even if the price of the underlying stocks remains the same for days at a time, both calls and puts will decrease in value because of the time decay. So in order to profit from options, you have to not only be right about the stock's direction, but you have to time it near perfectly as well to avoid your position from being eaten away by time decay.
Time decay, along with other factors that go into analyzing options contracts, are represented by what are known as Greeks. The Greeks are theta, vega, delta, and gamma. Like I said, the meaning of this post is really just to cover the basics so I'm not going to go into a ton of detail on the Greeks in this post, but I do at least want to explain theta. Theta is the greek representing time decay in options. You can see an options theta (along with the other Greeks) before you even trade it and it can tell you how much the contract is expected to be affected by time decay. Generally, the theta will be higher for OTM options because they affected more significantly by time decay since they ultimately expire at $0. Similarly, theta will be higher for options that are a few weeks away from expiration compared to options a few months away from expiration, because they lose more value as the expiration date approaches.
Theta makes general trading rules like "don't fight the trend" even more important. For example, if you bought calls in a downtrending stock because you thought that it was near its bottom, you would end up losing money because of theta if that stock did bottom out and started to consolidate at support. So in this situation you'd be correct about the stock finding the bottom, but you would still lose money if it didn't start to bounce back up quickly. If you had just bought the underlying stock rather than call options, you'd be at breakeven as the stock found its temporary bottom and began consolidating at support.
Although time decay can have a major negative impact on your options trades, there is actually a way to have it work in your favor. You can short options contracts, which is also called writing. Just like with shorting stocks, you profit from the price going down so time decay create profits for options that you sold short. In my opinion, this should really only be done by experienced traders though because writing options creates more overall risk than regular buying and selling.
The reason is because there is technically no limit to how how options can go and if you short either calls or puts, you would lose money as the options increase in price. It's the same reason that many people are afraid to short-sell stocks, but options are generally more volatile, which creates even more risk. Even though I wouldn't necessarily recommend it for beginners, I wanted to at least explain the concept of writing options in this post.
Regardless of how you trade options, it's important to at least understand all of these factors that go into their fluctuations and how their premiums are priced. Like any other type of trading, you should only be using money that you can afford to lose in its entirety while trading options... especially if you're trading the extremely volatile contracts that are near their expiration, which are the ones that attract so many traders because of their ability to make big runs in a short period of time.
Maybe after this you'll see why I stick to trading stocks rather than options. They can definitely be a great tools for experienced traders, but they're much more complex than most new traders think and can be very dangerous for inexperienced traders that are enticed by the big potential returns.
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