Strike Price: This is the agreed-upon price at which the buyer of the option can buy (or sell) the underlying asset. If you own an option, you can choose to "exercise" it, meaning you decide to buy (or sell) the asset at this strike price before the option expires.
How is an Option's Value Determined? The cost of an option is made up of two main parts: intrinsic value and time value. The intrinsic value is there if the option allows you to buy an asset for less than its current market value or sell it for more. Essentially, it's the profit you'd make if you exercised the option right away.
The time value is a bit like paying for the potential that the option's value could increase before it expires. It's what people are willing to pay on top of the intrinsic value for the chance that the market moves in their favor.
In the Money (ITM) vs. Out of the Money (OTM) vs. At the Money (ATM):
- ITM means the option would make you money if you exercised it right now. For a call option, this is when the strike price is below the current market price of the asset.
- OTM is when the option wouldn't make money if exercised at the moment, usually because the market hasn't moved as expected.
- ATM is when the option's strike price and the asset's market price are the same. This is often where a lot of trading happens because the outcome is still very uncertain.
For example, if NVDA is trading at $700 and you have a call option with a strike price of $600 (MAR 15 $600C), you're "in the money" by $100 because you could buy the stock for $600 and it's currently worth $700.
Exercising Options: Most of the time, buying an option is done for trading purposes rather than actually wanting to buy or sell the underlying asset. If you do end up holding an option until its expiration date, your broker might automatically exercise it for you, meaning they'll complete the buy or sell order based on your option's terms. So, keep an eye on expiration dates to avoid surprises.
At the end of the day, an option's value at expiration is exactly its intrinsic value. If it's ITM, you have a value equal to the difference between the asset's market price and the strike price. If it's OTM, it's worth nothing.
Volatility & IV
Implied Volatility (IV) is essentially a forecast of a stock's potential movement as seen by the market. It's a measure of the expected fluctuation in a stock's price over the lifetime of an option contract. When traders expect a significant price move, the IV goes up because a larger movement is "implied." This concept is important because finding options with lower IV can lead to more profit if the trade goes in your favor and smaller losses if it doesn't.
The IV changes constantly due to shifts in option prices and market conditions. The balance between how much people are willing to buy and sell an option for determines its price, which can be represented through IV.
Although "premium" technically refers to the price of an option, because IV is calculated from this price, traders often use the terms "premium" and "IV" interchangeably.
One strategy taught to new traders is to sell options when they seem overpriced (the price is higher than its theoretical value) and buy them when they are underpriced (the price is lower than its theoretical value). This approach aims to establish a favorable position from the start.
How to approach IV:
- If IV is low compared to what you expect the stock's volatility to be, it might be a good time to buy options.
- If IV is high, indicating that the option may be overpriced and might lose value faster (known as "theta decay"), selling options could be advantageous.
Generally, options that are "in the money" (meaning they would be profitable to exercise) are less affected by changes in IV compared to "out of the money" options (which are not profitable to exercise). This makes in-the-money options a more stable choice in volatile markets.
Risk Management Basics
A key rule for beginners: avoid shorting stocks or going against the market trend. Experience has taught me that aligning with the overall market direction usually results in more profits and less stress.
Understanding Option Greeks
Option Greeks are crucial metrics that help traders understand how different factors influence the price of an options contract. The main Greeks - delta, gamma, theta, and vega - each measure a different aspect of the option's risk and potential price movement.
Delta
Delta measures how much the price of an option is expected to move based on a $1 change in the underlying asset's price. A positive delta suggests the option's price will increase if the underlying asset's price goes up, and a negative delta indicates the opposite. Essentially, delta can help you gauge the option's sensitivity to the asset's price movement. At expiration, an option's worth is its intrinsic value. For example, owning 100 shares of a stock gives you a delta of 100. If you have an option with a delta of -75, your net exposure is reduced, demonstrating how delta can be used for hedging.
Gamma
Gamma reflects how delta changes as the underlying asset's price moves. It shows the rate of change in delta for every $1 movement in the asset. If an option's delta changes with the asset's price, gamma helps you understand how quickly that adjustment happens.
Theta
Theta represents the rate at which an option's value decreases over time, assuming all other market conditions stay the same. It's the cost of time, showing how much value an option loses as each day passes. This is why options are often seen losing value as they approach expiration.
Rho
Rho measures how much an option's price could change with a 1% change in interest rates. It's less relevant for beginners and not a focus in this discussion, aligning with our goal to keep things beginner-friendly.
Risk Management and Trading Strategy
Understanding these Greeks is essential, not just for selecting which options to trade but for determining how much of your portfolio to risk on each trade. I recommend never risking more than 5% of your options budget on a single trade. For instance, with a $100,000 account, limit any option position to no more than $5,000.
While the Greeks are invaluable for risk analysis, don't get bogged down by them. I usually check them to ensure nothing looks off, then concentrate on the option's trading volume. High volume means it's easier to sell the option later, potentially at a higher price. Low volume could make it hard to sell, possibly forcing you to accept a lower price. Understanding and utilizing volume is crucial as we explore different options trading strategies.
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