Options Trading Guide
Anyone familiar with stocks as an active trader or as a passive investor will know about options. Options are just another financial instrument that can either augment or be a main stay of your trading strategy. The possibilities are endless but we will focus on trading options speculatively for newer traders. This guide will cover the basics on options, how much capital is recommended, the brokers to use, and tips based on our trading experience.
Options are a financial instrument that give the holder the right but not the obligation (unlike futures contracts), to buy or sell the underlying financial instrument at a fixed price. Although there are futures options (options on futures contracts), most of the popularity and therefore analysis, is on US equity options. Each option controls 100 shares of stock with the except in situations like a reverse split. For example, a stock with a 10:1 split, meaning if there were 10 million shares outstanding, then post reverse split, there are only 1 million shares. Options that were issued before the reverse split now only control 10 shares. For those of you curious, futures options only control 1 futures contract.
Calls are options to buy a stock at a strike (fixed) price and puts are options to sell a stock at a given strike price. In the most basic form, you buy calls when you believe the price of the underlying stock will go up and puts if you believe the stock price will go down.
There are many different ways options pricing models but it all comes down to three parts.
The intrinsic value is the difference between the strike price of the option and the current trading price. There is only intrinsic value if the option is "in the money." That means for calls, the strike price is below the current stock price. For example, if AAPL is trading at $180 a share, then a call option with a strike price of $175 has a intrinsic value of $5 because it gives the call holder to buy the stock for a lower price. Likewise, puts only have intrinsic value if the strike price of the put is above the current trading price of the stock. For example, if AAPL is trading at $180 a share, then puts with a strike price of $185 have an intrinsic value of $5 because it gives the put holder the right to sell the stock for $5 more than the current trading price.
Options have fixed expiration dates and for stocks, it is always on a Friday. Certain ETFs like SPY, the ETF that follows SP500, have options that expire on both Wednesday and Friday. As the time left on the option decreases, then the value of the option decreases. The important thing here is that the loss of value during the last 30 days, or about 20 trading sessions, is exponential. The closer to the expiration date, the bigger the loss of value.
Of all the factors that affect options pricing, this one is the most important to understand. While the time value and intrinsic value can be calculated based on known factors, implied volatility is constantly changing. It is a measure of trader's expectations of volatility of the underlying stock. For that reason, it is sometimes called the "excitement factor." For example, if AAPL is trading at $190/share but drops suddenly to $185, implied volatility and the AAPL options will jump. For example, AAPL puts expiring within one week may increase from $.85 to $1.50. But here is the important thing: once the selling slows, implied volatility will likely drop so the value of those puts drop as a consequence. Even if AAPL slowly grinds down to $184, the value of those weekly expiring puts may trade at the same price as when AAPL initially dropped to $185. In short, when price moves quickly, implied volatility jumps up and options jump as well. This is true for calls and puts. Those of you thinking you can knife catch the rip or dip, may be disappointed if price does not only reverse, but reverse quickly.
A commonly used term for a drop in implied volatility is called "IV crush." The name implies that the holder of options will have their profits, if any, crushed once volatility drops. This is especially true before a stock has an earnings release. About two weeks before earnings release, implied volatility will climb expecting a large move. Newer traders who buy options and hold through earnings may initially rejoice when they have correctly picked the direction of the stock but subsequently disappointed when their profits are not nearly as much as they believed it to be. The reason is IV crush. Once earnings is released, traders expect the stock to be less volatile going forward.
This depends entirely on your risk profile. A general rule is not to risk more than 5-10% of your account on any single play because of the inherent risk. We will discuss this further below but as an options buyer, options move as fast as penny stocks but the clock and IV crush work against you. The benefit is that the options market for the biggest names and exchange-traded funds are much more liquid than penny stocks. For some forms of options seller, there is a risk of an adverse event that can cause you to lose even more than the capital available in your account. In contrast, option buyer's risks are limited to their position. Similar to futures and other derivatives trading, options trading is a zero-sum game: there must be losers for there to be winners.
You should only be concerned with the $25,000 threshold in your decision to open a cash or margin account because options trading, like stock trading, is regulated by FINRA. FINRA labels traders a Pattern Day Trader if their account is less than $25,000. This only applies to margin accounts. A margin account is basically an account in which your broker lends your funds for trading (most brokers allow for 2:1 margin to capital ratio). Similar to short selling stocks, it is required for selling to open any options positions.
We focus buying options, holding for an appreciation of value, and selling it for profit. Most options traders do not need a margin account in that case. While settlement for trading stocks have become more competitive at T+2, options settle only in T+1. That means your funds are ready to trade the next day!
There are much more advanced strategies involving buying certain expiration dates and sell others of the same underlying stock. It may sound confusing for now, but you will learn to use those strategies over time. The important thing is to have a good forecast of the direction the underlying stock will move, when it will move, and how big the move will be. It is slightly more complicated than trading stocks because of the time and implied volatility element.
Similar to trading stocks, Robinhood offers free options trading. Robinhood started as a mobile platform available on iOS and Android but added a web-based trading platform. It does not get much better than free but Robinhood comes with one major caveat: options trading is only available with a margin account. If you have less than $25,000 and do not mind being restricted to the limitations of pattern day trader rule (three trades per 5 days), then Robinhood is the best choice. If you want to trade more often or have more than $25,000, keep reading. There are better choices.
Jellifin is a relatively new stock and options broker. The biggest advantage of Jellifin is the subscription-based options trading. Commissions on options traded are priced by the contract so if you tend to trade many lower dollar-valued options contracts relative to your account size, then commissions can quickly add up. For example, buying 10 weekly calls on SPY priced at $.34, you would pay $340 and at $.70 per a contract, roundtrip is $14 for those ten contracts. In that situation, you are already down more than 4% from commissions alone.
The subscription fees on Jellifin are reasonable if you are an active trader. Unlike Robinhood, Jellifin offers cash accounts so you are not subject to Pattern Day Trader rules. It is the best option for active and small accounts. The biggest con with Jellifin is that it is only available on iOS 11.0 and higher No web-based or desktop platform. However, Android is supposedly in development.
Tastyworks is also a relatively new created by the founders of the popular trading platform, Thinkorswim. If you have $25,000 or more, or do not mind paying a little more in commissions, then this is our recommendation. Unlike the former two, Tastyworks is available in desktop, iOS, and Android. It is still lower commissions compared to the bigger names such as Interactive Broker. The pricing is straightfoward as seen in their advertising. The next images will give you an idea of why this is a better platform.
If you are joining us at Enhanced investor, the biggest advantage of a broker like Tastyworks is the ability to trade options on the SPX index. If you join our chatroom, you will see quite of few of our successful traders make their profits trading SPX options.
Options Trading Strategies
There are about 50+ different types of options plays, usually a mix of buying some combination of calls and puts, not necessarily with the same expiration date. Suffice to say, it can be confusing for new traders. But to be profitable, all you need to be able to do is forecast, with proper risk management, where the underlying is going, when, and how fast. Your forecast will determine the strategy you use, not the other way around. So while it can be confusing at first, it is important not to lose focus and realize that trading options is similar to trading anything else, with some small differences.
Choosing The Right Option
Okay, so you have opened your account, funded, and have a strategy. You look at the option chain and see a many different expiration dates and strike prices. There are a few guidelines to follow to avoid the common traps for new traders.
- Picking a strike price that is OTM (out of the money) or far away from where the stock is currently trading is not advised unless you believe a move in your favor will happen imminently. It is less risky to buy ATM (around the money) or a strike price that is close to where the stock is currently trading.
- Alternatively, going further OTM can be rewarding if you buy options with enough time remaining. Less risky are options with at least three weeks to a month expiration date. Buying weeklies (options that expiration in 5 or less trading sessions) may seem tempting because of the potential gains and cheap price but 95% of the time, IV crush and time decay will reduce your profits to nothing.
- If you take a position into earnings, you not only have to get the correct direction but be confident that the post-earnings move is greater than the implied volatility that is already priced into the option pre-earnings.
- Similar to penny stocks, always use limit orders. Unlike penny stocks, what seems like a wide bid-ask spread is actually not as much. For stocks, brokerages are required to post the NBBO (National Best Bid and Offer) and what you see is generally what you get. But for options there are hidden bids and asks so if there is a $.05 spread, you may get filled for as little as $.01 away from the bid.
- Stops are based on the ask price only. This differs from stocks where it is based on last traded. For less liquid options, the underlying stock can move in one direction and the bid can drop but the ask will not move. This will fail to trigger your stops and cause an even bigger loss when you do sell to close.
A Final Word
Options can seem attractive because for many options of popular underlying stocks such as AAPL or ETFs like SPY, they active like a more liquid penny stock. But do not underestimate the decay and IV crush that can turn a profitable trade into a losing one. Many times have we seen the underlying stock trade in the direction of the option holder but still be a losing trade because of decay. Nonetheless, played correctly and accurately, options can be immensely profitable with excellent risk to reward potential.