Options Basics Tutorial: Best Brokers For Options Trading

3/11/2019 Options Basics Tutorial
INVESTING OPTIONS
Options Basics Tutorial
BY LUCAS DOWNEY | Updated Jan 16, 2019
Introduction
We’ve all heard of options. They may seem overwhelming to think about, but options are easy
to understand if you know a few key points. Investor portfolios are usually constructed with
several asset classes. These may be stocks, bonds, ETFs, and even mutual funds. Options are
another asset class, and when used correctly, they offer many advantages that trading stocks
and ETFs alone cannot. Options can be purchased like most other asset classes with brokerage
investment accounts. You can check out some of the best places to trade in options with
Investopedia's list of the best brokers for options trading.
Which ETFs deliver value and convenience?

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Options are powerful because they can enhance an individual’s portfolio. They do this through
added income, protection, and even leverage. Depending on the situation, there is usually an
option scenario appropriate for an investor’s goal. A popular example would be using options as
an effective hedge against a declining stock market to limit downside losses. Options can also
be used to generate recurring income. Additionally, they are often used for speculative
purposes such as wagering on the direction of a stock.
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The best way to think about options is this:
“Options give you options.”
There is no free lunch with stocks and bonds. Options are no different. Options trading involves
certain risks that the investor must be aware of before making a trade. This is why, when trading
options with a broker, you usually see a disclaimer similar to the following:
Options involve risks and are not suitable for everyone. Option trading can be speculative in
nature and carry substantial risk of loss. Only invest with risk capital.
Options belong to the larger group of securities known as derivatives. This word is often
associated with excessive risk-taking and having the ability to bring down economies. Even
Warren Buffett has referred to derivatives as “weapons of mass destruction.” That perception,
however, is really overblown.
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All “derivative” means is that its price is dependent on, or derived from the price of something
else. Think of it this way: wine is a derivative of grapes; ketchup is a derivative of tomatoes; a
stock option is a derivative of a stock.
Options are derivatives of financial securities – their value depends on the price of some other
asset. That is essentially what the term, derivative, means. There are many different types of
securities that fall under the label of derivative, including calls,
puts, futures, forwards, swaps (of which there are many types), and mortgage-backed
securities, among many others. In the 2008 crisis, mortgage-backed securities and a particular
type of swap caused all the trouble. Options were largely blameless. (See also: 10 Options
Strategies To Know.)
If you know how options work, and how to use them appropriately, you can have a real
advantage in the market. Most importantly, options can allow you to put the odds in your favor.
If using options for speculation doesn't fit your style, no problem – you can use options without
speculating. Even if you decide never to use options, it is still important to understand how
companies you invest in use them. For instance, they might hedge foreign-exchange risk, or give
employees potential stock ownership in the form of stock options. Most multi-national
corporations today use options in some form or another.
This tutorial will introduce you to the fundamentals of stock options. The concepts can be
broadly applied to assets other than stocks, too. Many options traders have years of experience,
so don't expect to be an expert immediately after reading this tutorial. If you aren't familiar with
how the stock market works, you might want to check out the Stock Basics tutorial first.
Call and Put Options

Options are a type of derivative security. An option is a derivative because its price is
intrinsically linked to the price of something else. Remember: “options give you options.”
If you buy an options contract, it grants you the right, but not the obligation to buy or sell an
underlying asset at a set price on or before a certain date. A call option gives the holder the right
to buy stock and a put option gives the holder the right to sell stock.
Calls and Puts

Think of a call option as a down-payment for a future purpose. Let’s look at an example:
A potential homeowner sees a new development going up. That person may want the right to
purchase a home in the future, but will only want to exercise that right once certain
developments around the area are built. For instance, will there be a school going up soon? Or
will there be a garbage dump coming? These circumstances would affect their decision to buy
the home. The potential home buyer would benefit from the option of buying or not. Imagine
they can buy a call option from the developer to buy the home at say $400,000 at any point in
the next three years. Well, they can – you know it as a non-refundable deposit. Naturally, the
developer wouldn’t grant such an option for free. The potential home buyer needs to contribute
a down-payment to lock in that right.
With respect to an option, this cost is known as the premium. It is the price of the option
contract. In our home example, the deposit might be $20,000 that the buyer pays the developer.
Let’s say two years have passed, and now the developments are built and zoning has been
approved. No garbage dump is coming nearby. The home buyer exercises the option and buys
the home for $400,000, because that is the contract purchased. The market value of that home
may have doubled to $800,000. But because the down payment locked in a pre-determined
price, the buyer pays $400,000. Now, in an alternate scenario, say the zoning approval doesn’t
come through until year four. This is one year past the expiration of this option. Now the home
buyer must pay market price because the contract has expired. In either case, the developer
keeps the original $20,000 collected.
Take a look at the example below – it’s an excerpt from my Options for Beginners course
introducing the concept of call options:
4:10
Call Option Basics
Now, think of a put option as an insurance policy. If you own your home, you are likely familiar
with purchasing homeowner’s insurance. A homeowner buys a homeowner’s policy to protect
their home from damage. They pay an amount called the premium, for some amount of time,
let’s say a year. The policy has a face value and gives the insurance holder protection in the
event the home is damaged.
What if, instead of a home, your asset was a stock or index investment? Similarly, if an investor
wants insurance on his/her S&P 500 index portfolio, they can purchase put options. An investor
may fear that a bear market is near and may be unwilling to lose more than 10% of their long
position in the S&P 500 index. If the S&P 500 is currently trading at $2500, he/she can purchase
a put option giving the right to sell the index at $2250, for example, at any point in the next two
years. If in six months the market crashes by 20% (500 points on the index), he/she has made
250 points by being able to sell the index at $2250 when it is trading at $2000 – a combined loss
of just 10%. In fact, even if the market drops to zero, the loss would only be 10% if this put
option is held. Again, purchasing the option will carry a cost (its premium), and if the market
doesn’t drop during that period, the maximum loss on the option is just the premium spent.
See below another excerpt from my Options for Beginners course where I introduce the concept
of put options:
5:26
Put Option Basics
These examples demonstrate some very important points:
First, when you buy an option, you have a right but not an obligation to do something with it.
For stocks and many options on futures, it’s not required to exercise your right to buy or sell
stock by expiration. However, if your option has value at expiration, in general, your broker will
automatically exercise the option. In our put example above, if the S&P 500 fell to zero at
expiration, the 2250 put is worth 2250. At expiration your put option would settle for the cash
value, causing a large gain on the hedge. Keep in mind that stocks are physically settled. Now,
back to our put example: if the S&P 500 went up to 3000 at expiration, your 2250 put is
worthless.
Second, the most you can lose when buying an option contract is the premium spent. This is an
attractive trait for many. Limited risk allows option buyers to sleep at night.
Third, an option is a contract on an underlying asset. Its price is derived from the underlying
asset’s price. That’s why options are derivatives. In this tutorial, the underlying asset will
typically be a stock or stock index, but as mentioned, options are actively traded on all sorts of
financial securities, such as bonds, foreign currencies, commodities, and yes, even
other derivatives!
Buying and Selling Calls and Puts: Four Cardinal Coordinates

Buying a stock gives you a long position. Buying a call option gives you a potential long position
in the underlying stock. Short-selling a stock gives you a short position. Selling a naked or
uncovered call gives you a potential short position in the underlying stock.
Buying a put option gives you a potential short position in the underlying stock. Selling a naked,
or unmarried, put gives you a potential long position in the underlying stock. Keeping these
four scenarios straight is crucial: they relate to the four things you can do with options: buy
calls; sell calls; buy puts; and sell puts.
People who buy options are called holders and those who sell options are called writers of
options. Here is the important distinction between holders and writers:
Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice
to exercise their rights. This limits the risk of buyers of options to only the premium spent.
Call writers and put writers (sellers), however, are obligated to buy or sell if the option
expires in-the-money (more on that below). This means that a seller may be required to
make good on a promise to buy or sell. It also implies that option sellers have exposure to
more, and in some cases unlimited, risks. This means writers can lose much more than the
price of the options premium.
Don't worry if this seems confusing – the important thing to know that there are these 4
fundamental scenarios to be aware of.
Options Terminology
To really understand options, you need to know the options market terminology.
The strike price of an option contract is the price at which an underlying stock can be bought or
sold. This is the price a stock price must go above (for calls) or go below (for puts) before a
position can be exercised for a profit. This must occur on or before the expiration date in order
to be in-the-money. In our example above, the strike price for the S&P 500 put option was 2250.
The index had to fall below 2250 on or before expiration to be exercised for a profit.
The expiration date, or expiry, of an option is the precise date that the option contract
terminates.
A listed option is an option that is traded on a national options exchange such as the Chicago

Board Options Exchange (CBOE). Listed options have fixed strike prices and expiration dates.
Each listed option represents 100 shares of stock (known as 1 contract).
For call options, the option is in-the-money if the share price is above the strike price. For
example:
ABC April 50 Call. ABC stock is trading at $55. The Call is $5 in-the-money.
A put option is in-the-money when the share price is below the strike price. For example:
ABC April 50 Put. ABC stock is trading at $45. The Put is $5 in-the-money.
The amount by which an option is in-the-money is also referred to as its intrinsic value. For
example:
ABC April 50 Call. ABC stock is trading at $55. The Call is $5 in-the-money and also has $5 of
intrinsic value.
An option is out-of-the-money if the price of the underlying remains below the strike price (for a
call), or above the strike price (for a put). An option is at-the-money when the price of the
underlying is at or very close to the strike price. For example:
ABC April 50 Call. ABC stock is trading at $45. The Call is out-of-the-money and also has no
intrinsic value.
ABC April 50 Put. ABC stock is trading at $55. The Put is out-of-the-money and also has no
intrinsic value.
ABC April 50 Call. ABC stock is trading at $50. The Call is at-the-money and also has no intrinsic
value.
ABC April 50 Put. ABC stock is trading at $50. The Put is at-the-money and also has no intrinsic
value.
Remember, the total cost (the price) of an option contract is called the premium. This price is
determined by a few factors, including:
stock price
strike price
time remaining until expiration (time value)
volatility
Although employee stock options aren't available for everyone to trade, they are still a type of
call option. Many companies use stock options as a way to attract and to keep talented
employees, especially management. They are similar to regular stock options in that the holder
has the right but not the obligation to purchase company stock. The employee stock option
contract, however, exists only between the holder and the company. It typically cannot be
exchanged with anybody else. A listed option however, is a contract between two parties that is
completely unrelated to the company and can be traded freely.
Why Use Options?

Speculation
Speculation is a wager on future price direction. A speculator might think the price of a stock
will go up, perhaps based on fundamental analysis or technical analysis. A speculator might buy
the stock or buy a call option on the stock. Speculating with a call option – instead of buying the
stock outright – is attractive to some traders since options provide leverage. An out-of-the
money call option may only cost a few dollars or even cents compared to the full price of a $100
stock. As an example:
XYZ stock is $100 per share. An investor who wants to buy 100 shares will do so at a cost of
$10,000. An XYZ 102 call option with one month till expiration may hypothetically be priced at
$2 per contract. One contract equals 100 shares of XYZ stock, so the total premium spent is
$200. With leverage, spending $200 vs $10,000 to potentially control the same amount of stock
is a huge difference.
The leverage component of options contributes to their reputation for being risky. It is
important to understand that when you buy an option, you must be correct in the direction of
the stock's movement, and also the magnitude and timing of this movement. In other words, to
succeed, you must correctly predict whether a stock will go up or down, and you have to
correctly predict the magnitude of price change. You also need to accurately predict the time
frame within which all of this will happen.
Hedging
Options were really invented for hedging purposes. Hedging with options is meant to reduce
risk at a reasonable cost. Here, we can think of using options like an insurance policy. Just as
you insure your house or car, options can be used to insure your investments against a
downturn. Critics of options may say “if you are so unsure of your stock pick that you need a
hedge, you shouldn't make the investment.” In reality, there is plenty of evidence that hedging
strategies can be useful. This is especially true for large institutions. The individual investor can
also benefit from hedging. Imagine that you want to buy technology stocks. But you also want
to limit losses. By using put options, you could limit your downside risk and enjoy all the upside
in a cost-effective way. For short sellers, call options can be used to limit losses if wrong –
especially during a short squeeze. (See also: Bill Ackman's Greatest Hits and Misses.)
Spreads
Spreads use two or more options positions of the same class. They combine having a market
opinion (speculation) with limiting losses (hedging). Spreads often limit potential upside as
well. Yet these strategies can still be desirable since they usually cost less when compared to a
single options leg. Vertical spreads involve selling one option to buy another. Generally, the
second option is the same type and same expiration, but different strike. Spreads really show
the versatility of options. A trader can construct a spread to profit from nearly any market
outcome. This even includes markets that don’t move up or down. We will talk more about
basic spreads later in this tutorial.
See below an excerpt from my Options for Beginners course where I introduce the concept of
spreads:
1:28
Spread
Combinations
Combinations are trades constructed with both a call and a put. There is a special type of
combination known as a “synthetic.” The point of a synthetic is to create an options position
that behaves like an underlying asset, but without actually controlling the asset. For example, if
you buy an at-the-money call and simultaneously sell an at-the money put on stock XYZ with
the same expiration and strike, you have created a synthetic long position in XYZ stock. You
don’t actually own XYZ because you never bought it. But the combination of your long call and
short put behaves almost exactly like owning stock.
Why not just buy the stock? Maybe some legal or regulatory reason restricts you from owning it.
But you may be allowed to create a synthetic position using options. A synthetic might also be
useful if the underlying asset is something like an index that is difficult to recreate from its
individual components.
How Options Work

An option is the potential to participate in a future price change. So, if you own a call, you can
participate in the uptrend of a stock without owning the stock. You have the option to
participate.
In terms of valuing option contracts, it is essentially all about determining the probabilities of
future price events. The more likely something is to occur, the more expensive an option would
be that profits from that event. For instance, a call value goes up as the stock (underlying) goes
up. This is the key to understanding the relative value of options.
Let’s look at an example of a call option on International Business Machines Corp. (IBM) with a
strike price of $200 expiring in three months. IBM is currently trading at $175. Remember,
owning the call option gives you the right, but not the obligation, to purchase 100 shares of IBM
at $200 at any point in the next three months. If the price of IBM rises above $200 at any point
within three months, then the call option will become in-the-money.
The less time there is until expiry, the less value an option will have. This is because the chances
of a price move in the underlying stock diminishes as we draw closer to expiry. This is why an
option is a wasting asset. If you buy a one-month option that is out of the money, and the stock
doesn’t move, the option becomes less valuable with each passing day. Since time is a
component to the price of an option, a one-month option is going to be less valuable than a
three-month option. This is because with more time available, the probability of a price move in
your favor increases, and vice versa.
Accordingly, the same option strike that expires in a year will cost more than the same strike for
one month.
This wasting feature of options is a result of time decay. The same option will be worth less
tomorrow than it is today if the price of the stock doesn’t move.
See below an excerpt from my Options for Beginners course where I introduce the concept of
time decay:
4:23
Option
Let’s go back to our IBM three-month call example. The most important factor that increases the
value of your call is the price of IBM stock rising closer to $200. The closer the price of the stock
moves towards the strike, the more likely the call will expire in-the-money. Simply stated, as the
price of the underlying asset rises, the price of the call option premium will also rise.
Alternatively, as the price goes down – and the gap between the strike price and the underlying
asset price widens – the option will lose value. Similarly, if the price of IBM stock stays at $175,
the $190 strike call will be worth more than the $200 strike call, because the chance of IBM rising
to $190 is greater than the chance of reaching $200.
Volatility also increases the price of an option. This is because uncertainty pushes the odds of
an outcome higher. If the volatility of the underlying asset increases, larger price swings
increase the possibilities of substantial moves both up and down. Greater price swings will
increase the chances of an event occurring. Therefore, the greater the volatility, the greater the
price of the option. Options trading and volatility are intrinsically linked to each other in this
way.
With this in mind, let’s consider this hypothetical example. Let's say that on May 1, the stock
price of Cory's Tequila Co. (CTQ) is $67 and the premium (cost) is $3.15 for a July 70 Call. Seeing
only “July” with no date indicates that the expiration is the third Friday of July. The strike price
is $70. The total price of the call contract is $3.15 x 100 = $315. In reality, you’d need to consider
commissions, but we'll ignore them for this example.
On most U.S. exchanges, a stock option contract is the option to buy or sell 100 shares; that's
why you must multiply the contract premium ($3.15) by 100 to get the total amount you’ll have
to spend to buy the call ($315). The strike price of $70 means that the stock price must rise
above $70 before the call option has intrinsic value. Furthermore, because the contract is $3.15
per share, the break-even price at expiration would be $73.15 (Strike price + premium).
Three weeks later, the stock price has risen to $78. The call option contract has increased in
value along with the stock price and is now worth $8.25 x 100 = $825. Subtract what you paid for
the contract, and your profit is ($8.25 - $3.15) x 100 = $510. The call has $8.00 of intrinsic value.
Remember that for calls, stock price minus strike = intrinsic value. $78 - $70 = $8.00. The
remaining $0.25 is time value (more on this later).
In this scenario, you’ve almost doubled your money in just three weeks! You could sell your call
option, which is called "closing your position," and take your profits – unless, of course, you
think the stock price will continue to rise. For the sake of this example, let's say we let it ride.
By the expiration date, the price of CTQ drops down to $62. Because this is less than our $70
strike call option and there is no time left, the option contract expires worthless. We have no
position in the stock and we have only lost the original premium we spent of $315.
To recap, here is what happened to our option investment:
May 1 May 21 Expiry Date
Stock Price $67 $78 $62
Option Price $3.15 $8.25 worthless
Contract Value $315 $825 $0
Paper Gain/Loss $0 $510 -$315
So far, we've talked about the option holder having the right to buy or sell (exercise) the
underlying stock. While this is technically true, a majority of options are never exercised. In our
example, you could make money by exercising at $70 and then selling the stock back in the
market at $78 for a profit of $4.85 a share ($8.00 stock gain minus $3.15 premium). You could
also keep the stock, knowing you were able to buy it at a discount to the present value.
However, the majority of the time, holders choose to take their profits by trading out (closing
out) their position. This means that option holders sell their options in the market, and writers
buy their positions back to close. According to the CBOE , only about 10% of options are
exercised, 60% are traded (closed) out, and 30% expire worthless.
Now is a good time to dig deeper into pricing options. In our example, the premium (price) of
the option went from $3.15 to $8.25. These fluctuations can be explained by intrinsic
value and extrinsic value, which is also known as time value. An option's premium is the
combination of its intrinsic value and its time value. Intrinsic value is the in-the-money amount
of an options contract, which, for a call option, is the amount above the strike price that the
stock is trading. Time value represents the added value an investor has to pay for an option
above the intrinsic value. This is the extrinsic value, or time value. So, the price of the option in
our example can be thought of as the following:
Premium = Intrinsic Value + Time Value
$8.25 $8.00 $0.25
In real life, options almost always trade at some level above their intrinsic value, because the
probability of an event occurring is never absolutely zero, even if it is highly unlikely.
A brief word on options pricing. The market assigns a value to an option based on the likely
outcome relative to the underlying asset, as in the example above. But in order to put an
absolute price on an option, a pricing model must be used. The most well-known model is
the Black-Scholes-Merton model, which was derived in the 1970s, and for which the Nobel Prize
in economics was awarded. Since then, other models have emerged, such as binomial and
trinomial tree models, which are commonly used by professional options traders. In real life,
options almost always trade at some level above their intrinsic value, because the probability of
an event occurring is never absolutely zero, even if it is highly unlikely.
Types of Options
American and European Options
Now that we’ve talked about the differences between calls and puts, let’s explore some other
differences of categorizing options contracts. American options can be exercised at any time
between the date of purchase and the expiration date. The example of Cory's Tequila Co. shows
the use of an American option. Most exchange-traded options are American. European
options are different from American options in that they can only be exercised at the end of
their lives on their expiration date. The distinction between American and European options has
nothing to do with geography, only with early exercise. Many options on stock indexes are of the
European type. Because the right to exercise early has some value, an American option typically
carries a higher premium than an otherwise identical European option. This is because the early
exercise feature is desirable and commands a premium.
Options Expiration & Liquidity

Options can also be categorized by their duration. Short-term options are those that expire
generally within a year. Long-term options with expirations greater than a year are classified
as long-term equity anticipation securities, or LEAPs. LEAPS are identical to regular options,
they just have longer durations. Although they aren’t available on all stocks, LEAPS are available
on most widely held issues. You should know that LEAPS can be less liquid than shorter term
options, so they are not ideal for short-term trading.
Options can also be distinguished by when their expiration date falls. Traditionally, listed
options have expirations on the third Friday of the month. However due to increased demand,
sets of options now expire weekly on each Friday, at the end of the month, or even on a daily
basis. Index and ETF options also sometimes offer quarterly expiries.
Options Exchanges
Options traded on exchanges are called listed options. In the U.S., there are a number of
exchanges, both physical and electronic, where options are traded. For U.S. stocks, there are 15
options exchanges on the last count. Options can also be traded directly
between counterparties with the use of an exchange or an ISDA agreement; these are known
as over-the-counter (OTC) options. Often, financial institutions will use OTC options to tailor
specific outcome events that are not available among listed options.
Market makers exist in order to provide liquidity to options markets. They are required to

“make” a two-sided market in an option if asked to quote. Market makers, using theoretical
pricing models, can take advantage of arbitrage by exploiting theoretical mis-pricings between
the options’ perceived value and its market price.
The simple calls and puts we've discussed are sometimes referred to as plain vanilla options.
Even though the subject of options can be difficult to understand at first, these plain vanilla
options are as easy as it gets.
Because options are so versatile, there are many other types and variations of options. When
ordinary listed or OTC options won’t do, there are exotic options. They are exotic because there
might be a variation on the payoff profiles from the plain vanilla options. Or they can become
totally different products all together with "optionality" embedded in them. For
example, binary options have a simple payoff structure that is determined if the payoff event
happens regardless of the degree. Other types of exotic options include knock-out, knock-
in, barrier options, lookback options, Asian options and Bermudan options. Again, exotic
options are typically for professional derivatives traders.
How to Read An Options Table

Trading volume in options has steadily increased over the years. This is because more traders
are embracing the benefits options offer. Electronic trading platforms and information
dissemination have helped the trend as well.
Some traders use options to speculate on price direction. Others hedge existing or anticipated

positions, and others still attempt to craft unique positions that offer benefits not available to
trading just the underlying stock, index or futures contract. For example, one can profit from
options if the price of the underlying security doesn’t change at all.
Regardless of the objective, one of the keys to success is in picking the right option, or
combination of options, needed to create a position with the desired risk-to-reward trade-off(s).
As such, today's savvy option trader is typically looking at more sophisticated information when
it comes to options than the traders of decades past.
The Old Days of Option Price Reporting

In "the old days" some newspapers used to list rows and rows of nearly indecipherable option
price data deep within its financial section such as that displayed in Figure 1.
Figure 1: Option data from a newspaper.
Investor's Business Daily and the Wall Street Journal still include a partial listing of options data
for many of the more active optionable stocks and ETFs. The old newspaper listings included
mostly just the basics – a "P" for a put or a "C" for a call, the strike price, the last trade price for
the option, volume and open interest figures. Open interest means how many open option
contract positions there are. Today's option traders have a greater understanding of the
variables that drive option prices simply due to better technology advancing at a rapid pace.
Among these are a number of "Greek" values derived from an option pricing model, implied
option volatility and the bid/ask spreads. (Learn more in Using the Greeks to Understand
Options.)
Below is an understandable way to begin thinking of the concepts of Greeks that I teach in my
Options for Beginners course:
1:32
Using the Greeks to Understand Options
More and more traders are finding option data through online sources. While each source has its
own format for presenting the data, the key components generally include those listed in Figure
2 from Interactive Brokers. The variables listed are the ones most commonly used by today’s
options trader.
Figure 2: September call options for MSFT.
The data provided in Figure 2 provides the following information:
Column 1 – Volume (VLM): This

(VLM) simply tells you how many contracts of a particular option were
traded during the latest session. Typically – though not always – options with large volume will
have relatively tighter bid/ask spreads, as the competition to buy and sell these options is great.
Column 2 – Bid: The
Bid "bid" price is the latest price level at which a market participant wishes to
buy a particular option. What this means is that if you enter a "market order" to sell the
September 2018, 105 call, you would sell it at the bid price of $3.55.
Column 3 – Ask: The
Ask "ask" price is the latest price offered by a market participant to sell a
particular option. What this means is that if you enter a "market order" to buy the September
2018, 105 call, you would buy it at the ask price of $3.65.
NOTE
NOTE: Buying at the bid and selling at the ask is how market makers make their living. It is
imperative for an option trader to consider the difference between the bid and ask price when
considering any option trade. Typically, the more active the option, the tighter the bid/ask
spread. A wide spread indicates poor liquidity and can be problematic for any trader, especially
a short-term trader. If the bid is $3.55 and the ask is $3.65, the implication is that if you bought
the option one moment (at $3.65 ask) and turned around and sold it an instant later (at $3.55
bid), even though the price of the option did not change, you would lose -2.74% on the trade
((3.55-3.65)/3.65).
Column 4 – Implied Bid Volatility (IMPL BID VOL): Implied

VOL) volatility can be thought of as the
future uncertainty of price direction and speed. Think of a situation in which a future outcome,
like an earnings event, is very uncertain. This would be a situation with high implied volatility.
When we have an unclear idea of the future direction of a stock, uncertainty is high and so is
implied volatility.
This value is calculated by an option-pricing model such as the Black-Scholes model, and

represents the level of expected future volatility based on the current price of the option. It also
incorporates other known option-pricing variables (including the amount of time until
expiration, the difference between the strike price and the actual stock price and a risk-free
interest rate). The higher the Implied Volatility (IV), the more time premium is built into the price
of the option, and vice versa. If you have access to the historical range of IV, you can determine if
the current level of extrinsic value is presently on the high end (good for writing options) or low
end (good for buying options).
Column 5 – Open Interest (OPTN OP): This

OP) number indicates the total number of contracts of a
particular option that have been opened. Open interest decreases as open trades are closed.
Column 6 – Delta: Delta can
Delta be thought of as probability. For instance, a 30-delta option has
roughly a 30% chance of expiring in-the-money. Technically, Delta is a Greek value derived from
an option-pricing model, and it represents the "stock-equivalent position" for an option. The
delta of a call option can range from 0 to 100 (and for a put option, from 0 to -100). The
reward/risk characteristics associated with holding a call option with a delta of 50 is essentially
the same as holding 50 shares of stock. It also has a roughly 50% chance of expiring in the
money. If the stock goes up one full point, the option will gain roughly one half a point (50%).
The further an option is in-the-money, the more the position acts like a stock position. In other
words, as delta approaches 100 (100% probability of expiring in-the-money), the option trades
more and more like the underlying stock. So, an option with a 100-delta would gain or lose one
full point for each one dollar gain or loss in the underlying stock price.
(For more, check out Using the Greeks to Understand Options.)
Column 7 – Gamma (GMM): Think

(GMM) of gamma as the speed the option is moving in or out-of-the
money. Gamma can also be thought of as the movement of the delta. So gamma can answer
the question: how fast is my option moving towards becoming an in-the-money
option? Technically, gamma tells you how many deltas the option will gain or lose if the
underlying stock rises by one full point. For example, let’s say we bought the MSFT September
2018 105 call for $3.65. It has a delta of 65.70. In other words, if MSFT stock rises by a dollar, this
option should gain roughly 65.7 cents in value. If that happens, the option will gain 6.5 deltas
(the current gamma value) and would then have a delta of 72.2. From there another one point
gain in the price of the stock would result in a price gain for the option of roughly $0.722. So,
gamma helps us measure the speed of the movement of the option’s delta.
Column 7 – Vega: Vega is
Vega a Greek value that indicates the amount by which the price of the
option would be expected to change based on a one-point change in implied volatility. So
looking once again at the MSFT September 2018 105 call, if implied volatility rose one point –
from 17.313% to 18.313%, the price of this option would gain $0.123. This shows us why it is
preferable to buy options when implied volatility is low. You pay relatively less time premium,
and a rise in IV will inflate the price of the option. It is also better to write options when implied
volatility is high – more premium is available, and a decline in IV will decrease the price of the
option.
Column 8 – Theta: Options
Theta lose all time premium by expiration. "Time decay,”as it is known,
accelerates as expiration draws closer. When there’s no time left in an option, there’s no more
time value. At this point, the option either has intrinsic value or zero value. Theta is the Greek
value that indicates how much value an option will lose with the passage of one day's time. At
present, the MSFT September 2018 105 call will lose $0.034 of value due solely to the passage of
one day's time, even if the option and all other Greek values remain unchanged. Notice how
quickly time decay eats away at an option’s value just before expiry.
Figure 3: Time value as option nears expiration.
Column 9 – Strike: The
Strike "strike price" is the price at which the buyer of the option can buy or sell
the underlying security if he/she chooses to exercise the option. It is also the price at which the
writer of the option must sell or buy the underlying security if the option is assigned to him/her.
Like the table for calls above, a table for the respective put options would be similar, with two
primary differences:
1. Call options are more expensive the lower the strike price is, while put options are more
expensive the higher the strike price is. With calls, option prices decline as the strikes go
higher. This is because each higher strike price is less in-the-money (more out-of-the-money),
so higher strike calls contain less "intrinsic value" than the calls with lower strike prices.
2. With puts, it is just the opposite. As the strike prices increase, put options become either
less-out-of-the-money or more in-the-money and therefore contain more intrinsic value. So,
with puts, the option prices increase as the strike prices rise.
3. For call options, the delta values are positive and are higher at lower strike prices. For
instance, on a $30 stock, a $20 call may have a 90 delta while a $40 call may have a 10 delta.
For put options, the delta values are negative and are higher at higher strike prices. For
instance, on a $30 stock, a $20 put may have a -10 delta while a $40 put may have a -90 delta.
The negative values for put options come from the fact that they represent a stock-equivalent
position. Buying a put option is similar to entering a short position in a stock, hence the
negative delta value.
The level of sophistication of both options trading and the average options trader have come a
long way since trading in options began decades ago. Today's option quote screen reflects these
advances.
Options Spreads
Options spreads are a common strategy and involve buying and selling options of the same or
differing types, expirations, and strikes. You can also combine different options strategies,
known as combinations. In this section, we will provide a very basic overview of the most
common options spreads and combinations.
Long Calls/Puts, Straddles, and Strangles

The simplest options position is a long call (or put) by itself. This position profits if the price of
the underlying rises (falls), and your downside is limited to loss of the option premium spent. If
you simultaneously buy a call and put option with the same strike and expiration, you’ve
created a straddle. This position pays off if the underlying price rises or falls dramatically;
however if the price remains relatively stable, you lose premium on both the call and the put.
You would enter this strategy if you expect a large move in the stock but are not sure which
direction. Basically, you need the stock to have a move outside of a range. A similar strategy
betting on an outsized move in a security when you expect high volatility (uncertainty) is to buy
a call and buy a put with different strikes and the same expiration - known as a strangle. A
strangle requires larger price moves in either direction to profit, but is also less expensive than a
straddle. On the other hand, being short either a straddle or a strangle (selling both options)
would profit from a market that doesn’t move much.
Below is an explanation of straddles from my Options for Beginners course:
1:48
Straddles Academy
And here’s a description of strangles:
2:14
How to use Straddle Strategies
Call/Put Spreads and Butterflies
A bull call spread, or bull call vertical spread, is created by buying a call and simultaneously
selling another call with a higher strike price and the same expiration. The spread is profitable if
the underlying asset increases in price, but the upside is limited due to the short call strike. The
benefit, however, is that selling the higher strike call reduces the cost of buying the lower one.
Similarly, a bear put spread, or bear put vertical spread, involves buying a put and selling a
second put with a lower strike and the same expiration.
If you buy and sell options with different expirations, it is known as a calendar spread, or time
spread.
A butterfly consists of options at three strikes, equally spaced apart, where all options are of the
same type (either all calls or all puts) and have the same expiration. In a long butterfly, the
middle strike option is sold and the outside strikes are bought in a ratio of 1:2:1 (buy one, sell
two, buy one). If this ratio does not hold, it is not a butterfly. The outside strikes are commonly
referred to as the wings of the butterfly, and the inside strike as the body. The value of a
butterfly can never fall below zero. An example of a butterfly would be to go long a 70 call, short
two 75 calls, and long an 80 call. The identical spread could also be made with long the 70 put,
short two 75 puts, and long an 80 put. Being long a butterfly profits from a quiet market. Similar
to a butterfly are the condor, iron butterfly, and iron condor. The butterfly gets its name from
the shape of its profit-and-loss graph.
We addressed briefly how a synthetic position in the underlying can be created from options.
Combining options positions with the underlying can also produce synthetic options. This has
to do with what is known as put-call parity, where:
Call Price – Put Price = Underlying Price – Strike Price.
Rearranging this equation, we can create a synthetic long call for a given strike price by buying a
put and also buying the underlying. Similarly, a synthetic put is a long call combined with going
short the underlying. You can also create other combination strategies that include a trade in
the underlying, such as a collar or risk reversal.
Options Risks
Because options prices can be modeled mathematically with a model such as Black-Scholes,
many of the risks associated with options can also be modeled and understood. This particular
feature of options actually makes them arguably less risky than other asset classes, or at least
allows the risks associated with options to be understood and evaluated. Individual risks have
been assigned Greek letter names, and are sometimes referred to simply as the Greeks.
Again, below is a very basic way to begin thinking about the concepts of Greeks that I explain in
my Options for Beginners course:
1:32
Using the Greeks to Understand Options
Meet the Greeks

Delta is the change in option price per unit (point) change in the underlying price, and thus
represents the directional risk. Delta is interpreted as the hedge ratio, or alternatively, the
equivalent position in the underlying security: a 100-delta position is equivalent to being long
100 shares.
An easy way to think about delta is that it can represent the probability that an option has of
finishing in the money (a 40-delta option has a 40% chance of finishing in the money). At-the-
money options tend to have a delta near 50. Think about it this way, if you buy a stock today, it
has a 50% chance of going up and 50% chance of going down. In-the-money options typically
have a delta greater than 50, and out-of-the-money options are typically less than 50. Increasing
volatility or time to expiration, in general, causes deltas to increase.
Gamma measures the change in delta per unit (point) change in the underlying security. The
gamma shows how fast the delta will move if the underlying security moves a point. This is an
important value to watch, since it tells you how much more your directional risk increases as
the underlying moves. At-the-money options and those close to expiration have the largest
gammas. Volatility has an inverse relationship with gamma, so as volatility increases the
gamma of the option decreases.
Theta measures the change in option price per unit (day) change in time. Also known as time
decay risk, it represents how much value an option loses as time passes. Long-term options
decay at a slower rate than near-term options. Options near expiration and at-the-money have
the highest theta. Additionally, theta has a positive relationship with volatility, so as implied
volatility increases, theta also generally increases.
Vega measures the sensitivity of an option to volatility, represented as the change in option

price per unit (percent) change in volatility. If an option has a vega of .2 and the implied
volatility increases by 1%, the option value should increase by $.20. Options with more time till
expiration will have a higher vega value compared to those nearer to expiration. At-the-money
options are most sensitive to changes in vega.
Rho represents the option’s sensitivity to interest rate risk: the change in option price per unit
change in interest rates. A position with positive rho will be helped by an increase in interest
rates, and a negative rho will be helped by a decrease in interest rates.
Conclusion
We hope this tutorial has given you a practical view into the world of options. Options do not
have to be difficult to understand once you grasp the basic concepts. Options can provide
opportunities when used correctly, and can be harmful when used incorrectly. Please use this
tutorial as it was intended – as a starting point to learning more about options.
Let's recap:
An option is a contract giving the buyer the right but not the obligation to buy or sell an
underlying asset at a specific price on or before a certain date.
Options are derivatives because they derive their value from an underlying asset.
A call gives the holder the right to buy an asset at a certain price within a specific period of
time.
A put gives the holder the right to sell an asset at a certain price within a specific period of
time.
There are four types of participants in options markets: buyers of calls, sellers of calls,
buyers of puts, and sellers of puts.
Buyers are often referred to as holders, and sellers are also referred to as writers.
The price at which an underlying stock can be purchased or sold is called the strike price.
The total cost of an option is called the premium, which is determined by factors including
the stock price, strike price and time value remaining until expiration.
The premium of an option increases as the chances of the option finishing in-the-money
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increases.
A stock option contract typically represents 100 shares of the underlying stock.
Investors use options for income, to speculate, and to hedge risk.
Spreads and synthetic positions highlight the versatility of options contracts.
Employee stock options are different from listed options because they are a contract
between the company and the holder. (Employee stock options do not involve any third
parties.)
The two main classifications of options are American and European. Options can also be
distinguished as listed/OTC or vanilla/exotic, among other classification schemes.
Long-term options are known as LEAPS.
Option prices are determined by the Greeks, which allow for an option’s risk to be
understood and evaluated.
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What are some advantages of using options?

What are some advantages of using options?

How can options be used to generate income?

How can options be used to generate income?

3/11/2019 Options Basics Tutorial

Options Basics Tutorial

BY LUCAS DOWNEY | Updated Jan 16, 2019

Which ETFs deliver value and convenience?

The best way to think about options is this:

“Options give you options.”

New strategic alliance of ETF families

Call and Put Options

Calls and Puts

Call Option Basics

Put Option Basics

These examples demonstrate some very important points:

Buying and Selling Calls and Puts: Four Cardinal Coordinates

A listed option is an option that is traded on a national options exchange such as the Chicago

Why Use Options?

How Options Work

To recap, here is what happened to our option investment:

May 1 May 21 Expiry Date

Stock Price $67 $78 $62

Option Price $3.15 $8.25 worthless

Contract Value $315 $825 $0

Paper Gain/Loss $0 $510 -$315

Premium = Intrinsic Value + Time Value

$8.25 $8.00 $0.25

Options Expiration & Liquidity

Market makers exist in order to provide liquidity to options markets. They are required to

How to Read An Options Table

Some traders use options to speculate on price direction. Others hedge existing or anticipated

The Old Days of Option Price Reporting

Figure 1: Option data from a newspaper.

Using the Greeks to Understand Options

Figure 2: September call options for MSFT.

The data provided in Figure 2 provides the following information:

Column 1 – Volume (VLM): This

Column 4 – Implied Bid Volatility (IMPL BID VOL): Implied

This value is calculated by an option-pricing model such as the Black-Scholes model, and

Column 5 – Open Interest (OPTN OP): This

(For more, check out Using the Greeks to Understand Options.)

Column 7 – Gamma (GMM): Think

Figure 3: Time value as option nears expiration.

Long Calls/Puts, Straddles, and Strangles

Below is an explanation of straddles from my Options for Beginners course:

And here’s a description of strangles:

How to use Straddle Strategies

Call/Put Spreads and Butterflies

Call Price – Put Price = Underlying Price – Strike Price.

Using the Greeks to Understand Options

Meet the Greeks

Vega measures the sensitivity of an option to volatility, represented as the change in option

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What Is Option Moneyness?

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