THE ULTIMATE GUIDE TO
TRADING OPTIONS
Contents
03 Introduction
03 What are Options?
04 The Benefits of Options
06 The Risks of Options
07 How Options Work
10 What Are Spreads?
12 What Are Credit Spreads?
15 What Do I Need to Know About Expiration?
16 What Are Covered Calls?
18 What Are Protective Puts?
20 What is In/Out of the Money and Intrinsic/Extrinsic Values
22 What is Implied Volatility?
23 What is the VIX?
24 What Are Greeks?
25 Conclusion
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Introduction
Options are an increasingly important tool for retail investors and traders.
They can either replace individual stocks in your portfolio or make it easier to
position yourself in specific companies and exchange-traded funds (ETFs).
What are Options convey the right to buy or sell an underlying
Options? stock or ETF at a certain price over a certain time period.
Because they derive their price from something else,
options are known as derivatives.
Customers can buy or sell options. Either type of
transaction entails its own types of risks and potential
benefits.
Because options are complex instruments, they may not
be suited to all investors. However, traders who take the
time to learn options may find significant opportunities to
use their capital more effectively and manage risk.
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The Benefits of Options let you profit
Options from a stock moving,
without needing to own
the shares. Despite
1. Options Can Provide Leverage
having more risk of loss
than equities, they can
Options typically move more than their underlying
significantly reduce risk
stocks and ETFs and because they control a right
to buy or sell shares at a certain price. If the desired
when used correctly.
value — known as the strike price — isn’t reached,
they will expire worthless.
Options usually cost less than the underlying
stock or ETF. As a result, they can move more on
a percentage basis. This is another source of their
leverage.
Investors can use the leverage of options to
minimize capital at risk. For example, say a stock
moves 10 percent. A $1,000 option position could
potentially generate a similar amount of profit as
a $10,000 stock position. That can provide traders
more bang for their buck from stocks moving in
their favor.
However, traders should realize that options have
additional risks to stocks. One major risk is that they
can expire worthless.
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The Benefits of
Options
2. Options Can Be Used To Hedge
Positions
Because options are tied to specific stocks and
ETFs, investors can use them to reduce risk in those
underlying securities. This is also known as hedging.
Continue reading to see examples of hedging
strategies.
3. Options Can Be Used To Generate
Revenue
Options can be purchased, resulting in a cost or
debit. Traders can also sell them to collect the
premium, resulting in a credit to their account.
Credit strategies generate their potential profit
upfront, with the risk of losing a greater amount of
money in the future.
Debit strategies cost money upfront, with the
potential for greater profit in the future. For most
debit trades, the initial outlay is the most that can
be lost.
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The Benefits of
Options
4. Options Can Be Combined Into Spreads
Traders can take positions in two or more option contracts at a time. These multileg strategies, or
spreads, can further reduce risk.
The Risks of
Options
Because they are leveraged, options can
Options have time decay, which reduces
lose money rapidly if the trader predicts
their value as expiration approaches.
the underlier’s movement incorrectly.
Options often have less favorable pricing
Selling options can result in losses
because their bid/ask spreads can be
greater than the value of your account.
wider than equities.
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How
Options Work?
Options have existed for centuries but became widely available after the Chicago Board Options
Exchange (CBOE) was opened in 1973. CBOE’s options had standard features, making them uniform
and accessible to a much wider range of investors.
All options are either calls or puts:
CALLS give the right to buy PUTS give the right to sell
a stock. They generally gain a stock. They generally gain
value when shares rise. value when shares fall.
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Stock and ETF options potentially control 100 shares. They’re quoted at a per-share price but are
transacted in lots of 100. Therefore the value of any option transaction is 100 times the quoted premium.
Calls Puts
Gain value when Gain value when
How to Profit?
stock prices rise stock prices fall
Fix the price to buy Fix the price to sell
What they do?
a stock a stock
When you are When you are
When to buy?
bullish bearish
When you are When you are
When to sell?
neutral/bearish neutral/bullish
All options have three basic components:
1
An Underlier
2
A Strike Price
3
An Expiration Date
For example, Apple The price where AAPL The date at which the
(AAPL) common stock. can be bought or sold. option expires worthless
or must be exercised.
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Options Can Be Bought.
This costs money up front and results in a “long” position.
A
Long calls generally make money when the underlying
stock rises.
B
Long puts generally make money when the underlying
stock falls.
Options Can Be Sold.
This generates money upfront and results in a “short position.” Short options can be
highly risky when not combined with stock or other options.
Short calls generally lose money when the underlier rises.
A Investors holding stocks often sell calls against their
shares, which is known as a “covered call.”
Short puts generally lose money when the underlier
B declines. Investors often sell puts when they think a stock
has bottomed.
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What Are
SPREADS?
Spreads involve buying and selling two or more
options of the same type to form a single position.
For example, say stock XYZ is at $100,
and you expect it to rise to $110. You
could create a bullish spread like this:
· Buy the $105 calls for $2
· Sell the $110 calls for $1
This trade would cost a net $100 because
you’d pay $200 and receive $100.
If stock XYZ closes at $110 on expiration, the $105 calls would be worth $5, and the $110 calls would
be worthless. The spread would generate a 400 percent return ($4 profit versus $1 cost) from the stock
moving just 10 percent. This is a classic example of leverage.
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Call Debit Put Debit
Spread Spread
Stock rises to a certain Stock falls to a certain
How to Profit? level; usually, the strike of level; usually, the strike of
the contract sold the contract sold
The spread between the The spread between the
Profit potential two strike prices, minus the two strike prices, minus
initial cost/debit the initial cost/debit
Maximum Risk The initial cost/debit The initial cost/debit
Directional Bias Bullish Bearish
It can also work when prices decline. Say stock XYZ is at $100, and you expect it will fall to $90.
You could create a bearish spread like this:
· Buy the $95 puts for $2 This trade would also cost $1
· Sell the $90 puts for $1 because you'd pay $2 and receive $1.
If stock XYZ closes at $90 on expiration, the $95 puts would In both cases, using a spread
be worth $5, and the $90 puts would be worthless. The lowers cost. That can result
spread would generate a 400 percent return ($4 profit versus in greater leverage on a
$1 cost) from the stock moving just 10 percent. The same percentage basis.
leveraging principle applies in this case as the bullish strategy. (Lower cost = greater leverage)
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What Are
CREDIT SPREADS?
The examples above are debit spreads. They Because they’re the mirror image
have an upfront cost, with the potential for of debit spreads, bullish credit
profit later. They make money from certain
spreads involve puts, and bearish
levels being reached.
credit spreads use calls.
Credit spreads are just the opposite. They
generate revenue upfront, with the potential
for losses later. They make money from certain
levels not being reached.
For example, say stock XYZ is at $100, and you think it will remain above $95.
You can create a bullish credit spread like this:
· Sell the $95 puts for $2 This trade would generate a $1 credit
· Buy the $90 puts for $1 because you receive $2 and pay $1.
If stock XYZ closes at $95 or higher on expiration, both options will expire worthless, and you’ll keep the $1
as profit. However, you start to lose money if it drops under $95, with a maximum loss of $4 at or below $90.
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Put Credit Call Credit
Spread Spread
Stock remains above a Stock remains below a
How to Profit? certain level, usually the certain level, usually the
strike of the contract sold strike of the contract sold
Limited to the credit Limited to the credit
Profit potential
received when opened received when opened
The spread between the The spread between the
Maximum Risk two strike prices, minus the two strike prices, minus
initial credit the initial credit
Directional Bias Neutral / Bullish Neutral / Bearish
On the other hand, say stock XYZ is at $100, and you think it will remain below $105.
You can create a bearish credit spread like this:
- Sell the $105 calls for $2 This trade would generate a $1 credit
- Buy the $110 calls for $1 because you receive $2 and pay $1.
If stock XYZ closes at $105 or lower on expiration, both options will expire worthless, and you'll keep the $1 as
profit. However, you start to lose money if it rises above $105, with a maximum loss of $4 at or above $110.
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Here are the KEY POINTS TO REMEMBER
about the two types of spreads:
1
With debit spreads, you pay
2
With credit spreads, you receive
money with the expectation money with the expectation that
that something will happen. You something won’t happen. You
lose money if it doesn’t happen. lose money if it does happen.
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What Do I Need To Know
About Expiration?
The cases above only consider hypothetical option values at the expiration date. However, they have
other values beforehand. Here are some key things to know about options leading up to expiration:
1 In general, options with more time until expiration cost more.
2
Options lose value based on time decay, which is measured in theta.
(See the section on greeks below.)
3 Options lose value most quickly in their last six to eight days before expiration.
4
Expiration can be a major risk if you own calls in hope of a rally, or puts expecting
a decline.
5 Expiration can work in your favor if you’ve sold a credit spread.
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What Are
Covered Calls?
One of the most popular and lowest-risk options strategies is the covered call, which lets investors
collect returns on stocks they own. Say stock XYZ is at $100, and you own 100 shares. Using the same
values cited above, you could:
Sell one call at the $105 strike price and collect $2 per share or $200 in total.
This money is now yours to keep, effectively lowering your cost basis in the position.
If stock XYZ closes under $105, you keep the shares and the $2 extra per share.
If stock XYZ closes above $105, you must relinquish your position for $105.
But including the $2 you already collected, your effective exit price is $107.
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The benefit of covered calls is increased
certainty of making some profit and reduced
risk of loss — thanks to the premium collected.
This makes them a form of hedging.
In return for that certainty, you also lose the
right to profit from a bigger rally. If stock XYZ
advances all the way to $120 by expiration, this
covered call will still force you to exit at $105.
Covered calls are often used after
a stock rallies, and investors expect
a pause in the near-term. It’s less
bullish than owning shares outright
or owning calls.
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What Are
Protective Puts?
Protective puts are another popular strategy for investors looking to hedge a position in a stock. Say
stock XYZ is at $100, and you own 100 shares. If you’re concerned about it potentially dropping, you
could hypothetically do this:
Buy one put at the $95 strike, paying $2 per share.
If stock XYZ falls below $95, the puts will increase in value. That will offset losses on the 100
shares you own.
The $2 you spent on the puts raises your cost basis and reduces your profit.
Because of the $2 spent, your effective level of protection is $93.
Unlike the covered call, you still have unlimited upside potential.
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Covered Call Protective Put
How it works Sell calls to receive a credit Spend money to buy puts
Limited to the credit
Hedging Potential Unlimited
received when opened
Initial cost Low High
Potential
High Low
opportunity cost*
*Potential cost of missing a rally
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In the money/ Out of the Money
Intrinsic / Extrinsic values
Options are in the money when they have some value if exercised.
CALLS PUTS
Calls are in the money when Puts are in the money when the
the stock is above the strike stock is below the strike price.
price. After all, they let you buy Likewise, if they let you sell for
for less than the market price. more than the market, then
Therefore, they have real value. they have real value.
The amount that options are in the money is also known as intrinsic value.
Intrinsic value is the value of an option based only on its exercise price.
If stock XYZ is at $100, its $95 calls will If stock XYZ is at $100, its $105 puts will
have $5 of intrinsic value. have $5 of intrinsic value.
Any part of an option’s value that isn’t intrinsic or, in-the-money, is extrinsic value.
This is also known as time value.
Say stock XYZ is worth $100, and its $95 Say stock XYZ is worth $100, and its
calls cost $7. They have $5 of intrinsic $105 puts calls cost $7. They have $5 of
value and $2 of extrinsic value. intrinsic value and $2 of extrinsic value.
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If options aren’t “in the money,” they’re “out of the money.”
This is when calls or puts cannot be economically exercised.
CALLS PUTS
Calls are out of the money when Puts out of the money when the
the stock is below the strike price. stock is above the strike price.
If the current market price is below If the current market price is
the strike price, then it makes no above the strike price, it makes
sense to buy at the strike. no sense to sell at the strike.
Not surprisingly, all options that are “out of the money” also have zero intrinsic value. However, they
still are worth something because they have the potential to go in the money over time if the stock
moves past the strike price.
This is why longer-dated options cost more: They have
more time for the stock to move potentially in their favor.
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What Is Because options include
Implied the potential for
Volatility? movement, they cost
more for stocks that
tend to move a lot. This is
called “implied volatility.”
Implied volatility is the market’s
expectation of how much the
underlying shares can fluctuate. It’s
calculated on an annualized basis.
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What Is
The Vix?
VIX measures implied volatility on the S&P
500, the most widely used stock-market
benchmark. It’s calculated by the CBOE and
published as an index. The VIX generally rises
when the market begins to drop. Therefore
it’s often called the “fear index” or indicator of
overall sentiment.
While the VIX cannot be traded
directly, it has several related
products.
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What Are
The Greeks?
“Greeks” are a series of values that help describe options’ value and price behavior. These terms apply
to all options. They’re called Greeks because they’re named after the Black-Scholes mathematical
formula that uses Greek letters.
Delta describes how much an option’s value changes based on movements
in the underlying share price. It also indicates the probability of contracts
expiring worthless.
· Calls have positive delta because they gain in value when shares rise.
· Puts have negative delta because they move in the opposite direction.
Gamma describes how much an option’s delta changes based on movements
in the underlying share price. Gamma is always positive or zero.
Vega describes how much an option’s value fluctuates based on changes in
the underlier’s implied volatility. Vega is always positive or zero.
Theta describes how much time extrinsic value disappears each day because
of time decay. Theta is always negative or zero. It as a greater absolute value
(lower negative) the closer expiration is.
READY TO GET STARTED? 24
Conclusion
Thanks for reading TradeStation’s Retail Investors Guide to Trading Options. We
hope this overview of options trading will help you as you develop your own options
trading strategy and plan.
TradeStation is proud to serve the options traders and offers advanced tools to help
power your options trading, along with a dedicated team of options specialists and
one of the lowest pricing plans for options traders.
Learn more about trading options at TradeStation or level-up your options trading
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