How To Trade Options In 2021: A Beginner’s Guide To Options Trading

Just watching people blow up their trading accounts with options concern me, so I’m writing this guide for newer, less experienced options traders.

Options trading can be confusing. There are so many different factors to consider, including strike price, expiration date, and underlying stock price.

The good news is that you don’t need to be a financial expert to trade options. You can start trading options with little or no money at all. You just need a basic understanding of how options work and the right tools to employ in your portfolio of stocks, ETFs, bonds, etc.

In this post, we’ll explain everything you need to know and walk you through a real-life example to help you make smart trades.

Let’s get into it.

What Are Options?

Buying an option gives you the right to buy (call) or sell (put) 100 shares of stock at a specific price (strike price) on or before the expiration date. Buying calls are indicative of bullish movements in the stock and vice versa for buying puts as they are indicative of bearish movements in the stock.

Think about it.

If you buy a call option, you indicate to the market your intent to purchase stock at a future date; hence, increasing buy action on that stock.

To purchase an option, you will be paying a premium upfront to the counter-party, as they will be accepting uncertainty risk in terms of giving you the option to purchase stock from them.

So,

  • Buy call options when you believe a stock is going up;
  • Buy put options when you believe a stock is going down.

On the flip side, selling an option obligates you to buy (put) or sell (call) 100 shares of stock at the strike price at the expiration date.

So,

  • Sell call options when you believe a stock is going down;
  • Sell put options when you believe a stock is going up.

Making Money With Options Trading

Ranked in order of most profitable to least profitable, in the money options are the most profitable options as the stock price has reached or exceeded the strike price needed to turn a profit. Hence, the phrase “in the money”.

  1. In the Money
  • For call options, the stock price is above the strike price.
  • For put options, the stock price is below the strike price.

2. At the Money

  • For both call and options, the stock price is equivalent to the strike price.

3. Out of the Money

  • For call options, the stock price is above the strike price.
  • For put options, the stock price is below the strike price.

Inherent Risks Behind Trading Options

Although buying and selling options may seem simple enough, it’s essential to understand the worst-case scenarios when trading options. There are not so many risks when buying options as your worst-case scenario is you simply lose the entire value of the premiums purchased.

Selling options is a completely different story. When you sell options, your potential loss is unlimited for call options. How does this happen?

Let’s walk through a real-life example.

Breaking Down A GameStop Options Trade Example

I’m going to choose the stock GameStop and take a look at their option chain (a summary of pricing details for call and put options).

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options-chain

Source: Yahoo Finance

So, let’s break down this options trade.

  • Stock Price as of February 2, 2021: $90
  • Call Option Contract To Be Sold:
    • Strike Price: $130.00
    • Premium Price (Based on the Last Price): $20.00
    • Expiration Date: February 12, 2021

Option Premium: If we sell this Feb 12 Call-120, we will receive an option premium of $20. Great! We’ve already made a small profit off of our trade.

Ideal Scenario: Next, we wait until February 12 for the expiration date of the option contract. Ideally, the stock price will drop under the strike price of $120, and the call option will expire worthlessly.

Worst Case Scenario: But, in this example, I want to show you exactly how much we could potentially lose. Based on the 52-week range for GameStop stock, the stock price has gone up to a max of $483. So in the worst-case scenario, let’s assume on Feb 12, the stock price is $483.

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Option Assignment: If this happens, the call option owner will exercise their option on February 12 to purchase 100 shares of GameStop stock from you for $120. So, they will have to pay $12,000.

In your case, you don’t own the 100 shares of GameStop stock. Therefore, you are obligated to purchase 100 shares of GameStop stock at $483, which will cost you $48,300.

Conclusion: In the end, you will have earned $20 from the option premium and $12,000 from the call option owner purchasing the shares from you, as well as you will lose $48,300 to cover the purchase of 100 shares of GameStop. Ultimately, this will result in a $36,280 loss, not including commission fees and assignment fees from your broker…

Addendum: Although these losses look scary, there are many ways to make sure this doesn’t happen to you. For instance, your broker may have set margin limits to close your position if you happen to reach above a specific limit. Additionally, you can hedge this “naked” position by buying a call option to purchase shares at a lower price instead of at the current market price.

Understanding what your worst-case scenario is and how you can prevent it is imperative to trading success with options.

Always know your exit strategy.

Understanding The Greeks

An important question to ask yourself when options trading is, am I getting a good deal for the option premium. When buying options, you want to make sure you get the lowest price for the premium, and when selling options, the highest price.

So, what drives the value of these options?

Quite simply, it is the Greeks. No, it’s not Zeus or Hades pricing these options. It’s these greeks:

  • Δ (delta)
  • Γ (gamma)
  • Θ (theta)
  • σ (volatility)
  • ρ (rho)

For context, Greeks are derived from a pricing formula in the finance world called the Black-Scholes pricing model. This model is used for pricing options. The formula is extremely complicated, so we won’t go into detail about it. Each of the greeks listed above is a component of the Black-Scholes pricing model.

To give you an analogy, the Black-Scholes pricing model is the engine behind pricing these options, and the greeks are the moving parts inside the engine.

So, what do each of these Greeks affect?

Delta (Δ)

Delta is the change of the option price regarding the stock price based on a $1 change in the underlying stock. Calls have a positive delta, which is between 0 and 1. If other pricing variables remain constant, the call price will go up depending on the value of the delta.

options-chain

If we go back to our example of GameStop, the delta of a February 12 call option with a strike price of 95 has a delta of 0.43601. Therefore, if the stock goes up to $1, the call option will go up to $0.43601.

To understand more about this greek, it is essentially the probability an option will wind up at least $0.01 in the money at expiration. Typically, the delta increases as the stock price move closer to the strike price.

Additionally, when people talk about delta for options, they tend to drop the decimal point. So, they’ll say, “Just purchased a February 12 – 95 call option with 43 delta. Not too great, but it’ll move. You feel?”

Gamma (Γ)

Gamma isn’t as crucial as delta, but it can help measure how volatile a stock is.

Gamma is essentially the change of delta regarding the stock price based on a $1 change in the underlying stock. Think of it this way. Delta is presumed to be the velocity of the option’s price, and gamma is accelerating the option’s price.

So, if you have high gamma, that means the option is approaching in-the-money status soon. Looking back at our GameStop call option, its gamma is 0.01434. So, it’s doubtful to be in the money.

Theta (Θ)

Theta, otherwise known as time-decay, is essential in determining the expiration date for when you should buy or sell an option.

For theta, each day that passes by decreases the value of the option.

Why does this happen?

Say you have two options, both with the same strike price and all other pricing variables constant. The only difference between these two options is one expires at the end of this week and the other option expires at the end of the month.

Which option would you pick?

If you picked the option expiring at the end of the month, you would be correct. Having more time for the stock price to reach or exceed the strike price is valuable.

Vega (σ)

Vega is perhaps the most overlooked Greek for beginner options traders. A simple strategy I’ve seen fail for people is purchasing call options around earnings season with the expectation that the call option increases due to the stock price increase from positive earnings. This should work, right?

The logic is sound; however, options are much more complicated as implied volatility can also drive the value of options. This traces back to simple economics – supply and demand as a 536.57%. This is exceptionally high, which is most likely due to the recent GameStop rally. In most cases, implied volatility is typically under 100%.

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Rho (ρ)

Rho is the amount an option value changes based on a one-percentage-point change in interest rates. With the current low-interest-rate environment, rho does not have a significant impact on options.

With how stagnant interest rates have been for the past decade, rho has more impact on extremely long-dated options.

Disclaimer: I want to note that the Black-Scholes pricing model is merely an assumptive model to make sense of the value of options. There are many cases when the price of an option may be significantly mispriced. However, we can use this model as a reference.

Author

  • syao scaled

    Stephen Yao is a writer, ex-Deloitte financial engineer with expertise in the life insurance, pension, and capital markets industry. He lives in Toronto, Ontario, and writes about personal finance and career fulfillment.

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