How to Read an Options Table
Now that you have completed the Options Basics section, it is time to start preparing for real-time trading. In order to do this, you will need to have an understanding of the mechanics for the trades themselves. Option values are determined by elements like the amount of time until expiration, asset price volatility, and the distance between the strike price and the market valuation of the asset at the time of contract initiation. The models used for pricing options also create the Greeks, which are values that determine the relationship between option prices and the underlying asset.
This is where option tables come in handy, so it is important to understand how to read an option table before any real-money trades are placed. Here, we will explain how to read an option table and interpret the information it contains.
CBOE Option Table Database
Most options are priced through the Chicago Board Options exchange (CBOE). The CBOE website is www.CBOE.com, and options quotes can be found by clicking Quotes and Data, and then Quotes Dashboard. You can then enter a stock symbol or ETF symbol to find out more information on the asset, and to see which options are available.
Image Source: CBOE
The image above is a portion of the option chain currently available for the SPDR S&P 500 ETF TRUST, which is one of the most commonly traded stock index ETFs. If you look to the top right corner of each options table, you will see the expiry time for the option contract. Each of these options end in February but at the bottom of this web page (not pictured), there are link choices to select options contracts for each month of the upcoming year. Call options are always visible on the left side of the page, while put options are placed on the right side.
Next, we will explain the meaning of each column in the table.
At the top of the table, we can see the name and symbol of the underlying asset, which is SPDR S&P 500 ETF TRUST (SPY). We can also see the current price of the asset in the field marked “Last.” In this example, we can see that the current price of SPY is 209.78.
The first column shows the strike price of the option. If you are buying options, this is the price at which the asset can be purchased (when using call options) or sold (when using put options. When selling options, this is the price at which the option writer will produce the underlying asset of the option is exercised. This column shows numbers and letters that might seem complicated, but when we break down the components the information here is actually quite simple. Let’s take a closer look at the first column:
After the symbol for the asset (SPY), we have four numbers followed by a letter. The first two numbers represent the year, in this case 2015 (shown as 15). The next two numbers represent the day of expiration, in this case it is the 20th day of the month (shown as 20). The letter represents the month. For call options, the letters range from A (for January) to L (for December). In this example, we can see the letter is B, which stands for the second month of the year (February). For put options, the letters range from M (for January) to X (for December). In the puts section of the original graphic, we can see the letter is N which stands for the second month of the year (February).
The final number is the actual strike price for the option. In this example, the strike price is 209. This is important because this number will ultimately determine whether or not the trade closes in profitable territory. SInce this is a call option, prices will need to close above the strike price. If the trade was a put option, prices would need to close below the strike price. This table shows that the current market price is 209.78, so if SPY can hold these gains through the expiration period, the call option trade will close in positive territory.
For the most part, this is where the majority of the market’s attention is focused when trading options. But there are a few more columns that should be addressed in order to complete the discussion. To the right of the strike column is the Last column, which shows the most recent price for the option itself. The Net field shows the price change since the previous closing period. The Bid field shows the price at which buyers can purchase one share of the asset. Options contracts are traded in 100-share installments, so you must multiply this number by 100 in order to get the total price for buying an option The Ask field shows the price at which sellers can sell one share the asset. The Vol field is an abbreviation for volume, which is a measure of the number of contracts that have been traded during the current session. When an options contract has a higher trading volume, there is usually a smaller spread between the Bid and Ask prices for the asset.
Now that you have mastered the basics of options trading, it is time to “start getting your feet wet” and start placing real-time trades. But before you start committing your hard-earned money to such a vast enterprise, it is a good idea to start by applying your market outlook using a virtual trading platform.
This is a practice known as demo trading, and it can be highly valuable for those looking to protect themselves from unnecessary losses in what can be a volatile and somewhat unpredictable market. Here, we will discuss some of the benefits of demo trading and outline some of the ways options traders should use demo platforms as a means for developing a profitable strategy.
Mastering the Mechanics
Having an accurate understanding of how options trading works is a valuable asset — but nothing can replace active executions under live market conditions. Demo platforms operate no differently from accounts funded with real money, so this approach will allow you to master the mechanics of options without putting any money at risk. This is critically important, especially in the early stages of your options trading career. Minor mistakes can become costly if you start trading with real money, and there is nothing worse than losing money for mistakes that should have been avoidable.
Next, we will take a look at an options trading demo platform:
The format here should look familiar, as there are many similarities between the traditional trading platform and the options tables that are generated by the CBOE (see the first tutorial in this section). There are some additional features, however, as this is a platform that will enable you to place actual trades in the market (rather than simply showing the prices for call and put options). But most of the basic information here is the same, so as long as you have a strong understanding of how to read an options table you should have an easy enough time navigating your demo platform.
Developing Your Options Strategy
But demo trading does involve more than simply executing trades. Since demo platforms operate under live market conditions, you will be able to switch between different market strategies to see which is best for your financial goals. Do you want to place trades after major news events? Do you want to employ technical chart analysis in deciding your options outlook? Do you think you can profit more from trading stocks, commodities, or currencies? These are all questions that take a good deal of experience before a truly valid answer can be found, so trading with a real money account in the early stages of your career is the prudent approach and something that is almost universally recommended by experienced options traders.
In the graphic above, we can see some of the other features that are typically included as part of an options demo platform. On the right side of the graphic, we can see the virtual account balance. This is not real money, but it trades in the exact same fashion. Many trading platforms will offer both stock and options trading (as in this example), and some will also include access to futures markets. This example shows the total account balance relative to the options values can that be purchased at any time.
Toward the left side of the graphic, we can see the different types of options that can be traded along with the search fields that are used to find the specific assets that will be traded. Below the Symbol field, we can see the Price field, which is where traders select the most appropriate price for each trade. When traders select the Market price, trades will be executed at the current price values present in the market. When traders select the Limit/Credit choice, traders are able to select a price above or below the market values currently seen for the asset. The Duration field allows traders to select the length of time the trading order will remain active.
For example, if you place an order away from the current price and then select Day Order, the order will close at the end of the day if markets fail to reach your chosen price level. Durations can also be delineated as Good Until Cancelled, which will leave the order active unless it is triggered by the market or closed manually by the trader.
Finally, demo trading will allow you to assess the charting software that is made available by the broker. In this way, even experienced traders will open demo accounts in order to test the charting software that is available and assess whether or not it is suitable. In many cases, there can be significant differences in the charting software that is offered by different options brokers. So if you have any technical chart analysis that is used as part of your strategy, it is generally a good idea to avoid committing to a real-money account until you know that the charting software is going to be useful in determining your options positions.
Price Charts in Options Trading
In the previous section, we discussed the importance of charting software when trading options using a demo account. For options traders that are interested in implementing technical analysis strategies when determining their position outlook, there are a few different chart types that are available. Some chart types are more popular than others but all of these choices have their own sets of strengths and weaknesses.
But even if you are not planning on employing technical analysis strategies, it is important to have an understanding of each of the main chart types that are used in options trading. This way, you will be able to understand the analysis and jargon that is used by other traders you come across in the options community. Here, we will discuss the three main chart types that are used in options trading and show visual examples so that you can know which chart type you are dealing with in any given situation.
The first type of chart we will discuss here is the line chart, which is the type of chart most commonly referenced in the financial media. Line charts are the simplest of the three main chart types in options trading, but they can be highly useful when attempting to assess short-term trends. One example here might be to assess whether or not a certain stock had a positive day or a negative day.
Let’s look at an hourly chart in the FTSE 100:
Chart Source: Metatrader
In the graphic example above, we can see a simple line chart in the FTSE 100 that is based on the hourly time frame. Time values are plotted along the X-axis and price values are plotted along the Y-axis. Since this is an hourly chart, each price value is going to represent the market price at the close of each hour. All that is present on this chart is the asset’s price action in its barest form. This information is useful in determining the general trend over the time period in question. In this case, we can see that the FTSE 100 has managed to rally during the period.
Next, we look at the bar chart, which offers a bit more information to options traders. Let’s first take a look at the chart itself, and then discuss some of the added components that are made visible to traders.
Chart Source: Metatrader
Here, we have plotted the exact same price history in the FTSE 100 using a bar chart. On the bar chart, time values are also plotted on the X-axis while the price values are plotted on the Y-axis. But, visually, some differences should be apparent. Bar charts show values for the opening price, closing price, highest price, and lowest price for each time interval. Since this chart is an hourly chart, the price values will represent the open, close, high, and low for each plotted hour.
The high of the period is simply the highest price point marked by each bar. The low of the period is the lowest price point marked by each bar. The opening price is shown using a small horizontal line extending to the left of each price bar. The closing price is shown using a small horizontal line extending to the right of each price bar. Many bar charts use the same color for each price bar. The chart shown above is different in that positive price intervals are shown in black, while negative time intervals are shown in red. So, if the opening price is lower than the closing price, the price bar will be black. If the opening price is higher than the closing price, the price bar will be red. This extra information can be useful for those employing certain types of technical analysis strategies. For example, practitioners of Elliott Wave Theory tend to prefer bar charts because it allows traders to visualize more price behavior without detracting from the general trend.
Last, we look at the candlestick chart. Candlestick charts are the most complicated type of price chart and this is the most commonly used choice for traders that employ technical analysis strategies. Here is an example what what a candlestick chart looks like in active trading:
Chart Source: Metatrader
As you can probably notice, the candlestick chart displays additional price information that is not present in either line charts or bar charts. Each time interval in the candlestick chart resembles a candle, with its upper and lower “wicks.” These wicks represent the highest and lowest prices that were printed during the time interval.
The open and closing prices are also expressed, using the candle body — but this is done differently when compared to the bar chart. To understand which price level represents the open and which represents the close, we need to look at the color of the candle itself. In this example, positive price intervals are shown in green while negative price intervals are shown in red. If the candle is green, the opening price is the bottom of the candle body (which means the top of the candle body represents the closing price for the time interval). If the candle is red, the opening price is the top of the candle body (which means the bottom of the candle body represents the closing price for the time interval). Full candle bodies are typically thought to represent strong price moves, while small candle bodies are generally thought to represent periods of market indecision.
OTrading Price Trends in Options
Understanding the dominant trend in the market is important for all reforms of investment, whether you are trading stocks, buying or selling precious metals or investing in the currency markets. But the argument can be made that trend analysis is most important when trading options because you are essentially betting on whether the price of an asset will go up or go down in the future. For these reasons it is important to have a firm understanding of the ways options traders view price charts and perceive the dominant trends present in the market.
In the previous section, we looked at the various chart types that are available. Now, we will look at ways of using those chart types to identify which trend is most important for your chosen asset at any given time. The examples that follow will use candlestick charts, but the same logic can be applied to both bar and line charts. Trend analysis is by no means a guarantee that your trade will close profitably. But when options traders trade in the direction of the dominant trend, they are able to turn the odds into their favor and, in most cases, generate profits that surpass the negative results seen in any losing trades that are encountered.
If markets are experiencing an uptrend, the majority of the trading community has established a bullish outlook and is buying the asset in question. When there are more buyers than sellers in an asset, prices rise. When options traders are able to identify these scenarios in their earliest stages, call options can be purchased on the expectation that bullish momentum will force prices higher in the future. But how exactly do we know when an uptrend is in place? Let’s consider the following price chart in the S&P 500:
Chart Source: Metatrader
Here, we can clearly see that prices are rising in the S&P 500. But there are specific criteria that must be met in order to consider these types of pricing moves to be an uptrend. Specifically, options traders will need to see a series of higher highs, and higher lows. If this requirement is not in place, the uptrend might be ending (or perhaps it was never really there in the first place). This could be true even if prices continue to make small gains.
Chart Source: Metatrader
In this example, we can see the same price action with some of the key price points outlined. It is true that prices are rising throughout this time period. But options traders need to see that the market is breaking through previous resistance levels (to reach higher highs), and is finding support more easily at the upper levels (to create higher lows). Once this sequence is in place, options traders will consider the uptrend to be valid. This marks a suitable environment to start buying call options in the asset — which, in this case, is the S&P 500. If the series starts to break down — and we start to see lower highs and/or lower lows — the uptrend has likely run its course and is ready for reversal. Once this occurs, it is generally a good idea to take profits on like trades and close out your positions.
If markets are experiencing an downtrend, the majority of the trading community has established a bearish outlook and it selling the asset in question. When there are more sellers than buyers in an asset, prices fall. When options traders are able to identify downtrends early, put options can be purchased on the expectation that bearish momentum will force prices lower in the future. Let’s take a look at a visual downtrend example using a price history in gold:
Chart Source: Metatrader
Here, we can clearly see that prices are falling in gold. But in order to consider these pricing moves a true downtrend, options traders will need to see a series of lower highs, and lower lows. If this requirement is not in place, the downtrend might be ending (or no trend is really present). Next, we will highlight the key price points that allow options traders to know that the momentum in the asset is truly bearish and that a confirmed downtrend is in place.
Chart Source: Metatrader
In this example, we can see the same price action with some of the key price points outlined. It is true that prices are falling throughout this time period. But options traders need to see that the market is breaking through previous support levels (to reach lower lows), and is failing at resistance points (creating lower highs). Once this sequence is in place, options traders will consider the downtrend to be valid. This marks a suitable environment to start buying put options in the asset. The series would break down if we started to see higher lows and/or higher highs. This would mean that the downtrend has likely run its course and a reversal is imminent. If this occurs, options traders will look to take profits on like short trades and close out positions.
In these ways, options traders can use price trends as a means for establishing positions in the open market. Trend spotting might seem difficult in the early stages, but if you keep some basic rules in mind trends will become much easier to identify over time. Trends with a larger number of price points tend to be considered as stronger. So, for example, if you see a trend with four price points it will be considered stronger than one with three. A trend with five price points will be considered stronger than one with four, and so on.
Establishing a Market Outlook
Now that you are ready to start placing active trades in the options market, you will need to start constructing the analysis that will allow you to understand exactly which trades should be placed. It is not enough to simply choose an asset and then randomly select a positive or negative stance in the market. This type approach will create results that are no better than a simple coin flip, and this is no way to ensure consistent profits will be generated over time.
For these reasons, no trade should be placed unless you have an analytical argument supporting your outlook (positive or negative). In the previous article, we outlined some of the ways technical analysis traders are able to form a bias for an asset and then apply that bias to a real-money options trade. This approach is suitable for those working from a technical analysis perspective. But what about those looking to employ fundamental strategies, where economic factors affecting the price of an asset must be taken into consideration? Here, we will separate the major asset classes and discuss some of the elements that must be assessed in order to establish a market outlook and then use that outlook to construct real-money options trades.
Since stocks represent the most commonly traded options class, we will start with the factors influencing fundamental trends in this sector. Stocks are traded in two broad forms, as individual shares and as part of a stock index. There are some differences between these two forms, but most of the same underlying strategies apply. When dealing with individual stock shares, options traders must assess the strength or weakness of a company based on its current valuation and its ability to generate revenue.
When company’s stock is trading at elevated levels relatively to its competition, there must be strong reasons supporting potential bullish positions (call options) in the stock. For example, the company must show a strong record of recent revenue generation, or at least an expectation to start accomplishing this in the near future. Does the company have high-margin products in the pipeline? Has company management developed an approach to keep costs low while increasing profits? If so, call options might be appropriate. If not, it might be a good idea to consider betting against the company using put options.
When dealing with a stock index (such as the S&P 500, or the FTSE 100), the analysis must be broader in nature. Since an index is a large collection of stocks, strength or weakness will depend on trends seen across sectors. For example, those trading options in a stock index will need to assess the outlook for sectors like health care, consumer staples, energy, information technology, and telecommunication services. If strength is not to be found in at least half of these sectors, call options are unlikely to perform well or generate significant profits. Historically speaking, stock indices tend to perform positively over time. But this does not mean investors can simply buy call options in an instrument like the Dow Jones Industrials and expect to make gains on each trade. Valuations are always important, and the old market maxim suggesting investors should “buy low, and sell high” is something that should always be considered.
Developing a market outlook in commodities is quite different because there are no companies directly involved in these investments. Instead, investors need to make assessments on the level of supply and demand that can be found in the market at any given time. This can be more of a challenge, given the fact that there is no single source that is responsible for producing all of any raw material. But there are ways of determining the broader trends that are present in the market if investors look at the largest markets (both on the consumer and producer side).
For example, most of the world’s oil production is centered in the Middle East, Canada, and the United States. When production numbers out of these locations fall, oil prices tend to rise and call options before more appropriate. When production numbers rise, oil prices tend to fall and put options become more appropriate. At the same time, it is important to watch for data suggesting changes in consumer demand. For example, if the United States is expecting an uncharacteristically cold winter, the added demand for energy products will likely support market prices in oil. This would make call options appropriate. Alternatively, if we were to see a decrease in manufacturing activity in an emerging markets economy like China, the declines in demand could be used as a catalyst to buy put options in oil.
Last, we look at currency options which differ from the other two categories in that currency values are always expressed in terms of another currency. For example, the EUR/USD shows the value of one Euro in terms of US Dollars. For these reasons, investors trading in currency options will need to assess the relative strength of at least two separate economies. To accomplish this, investors trading currency options will assess the macroeconomic data in areas like inflation, GDP growth, unemployment, manufacturing productivity, and retail sales. Profitable trades in currency options can be found when traders are able to pair a strong currency with a weak currency.
Another factor to consider when trading currency options in the interest rate policy for both countries in question. If a central bank is likely to raise interest rates in the future, options traders will usually establish a bullish outlook for the currency. If a central bank is likely to cut interest rates in the future, options traders will usually establish a bearish outlook for the currency.
Stock Benchmarks: SPY vs. SPX
Most of the trading activity that is seen in options is tied to stock markets. This should not be entirely surprising because when we look at the financial news headlines, this is the area where most of the attention is centered. Strength or weakness in the stock market is often used as a basis for assessing activity in the economy as a whole, so investors that are able to assess future trends in stocks can often achieve profitability in other sectors as well. For these reasons, it makes sense to understand some of the different stock assets that are available for trading by options investors. For most of this article, we will be discussing the intricacies of the S&P 500, and the various instruments that can be used to trade this popular stock benchmark.
Assessing the Choices
For those looking to gain exposure to commonly traded stock benchmarks, there is a wide variety of choices available. The most commonly traded stock benchmark is the S&P 500, which is often used as an investment vehicle because it includes a large and diverse selection of companies with international reach. For options traders, trading in the S&P 500 has the added advantage of superior liquidity and stable trend activity. This leads to more predictable forecasts, which can make it easier to achieve profitability on a consistent basis.
The two most common vehicles for trading options in the S&P 500 can be found in the SPDR S&P 500 ETF Trust (which operates under the stock symbol SPY), and the S&P 500 Index (which trades on the CBOE under the symbol SPX). There are other methods for gaining exposure to the S&P 500. But these are the two most common choices, and there are some key benefits that can be captured when using these vehicles.
SPY is an exchange traded fund, or ETF, that is designed to mirror the price activity seen in the S&P 500. There are often minor differences in the price of SPY and in the S&P 500 itself because buying and selling activity in SPY is not directly connected to the S&P 500. Market forces determine the direction of both assets but these two entities tend to follow a similar trajectory. There are some advantages for those that choose to invest in SPY, as the ETF pays quarterly dividends and this tends to be viewed as a factor that supports the long-term outlook for SPY.
The SPX is the S&P 500 itself. It is an index that includes the 500 largest companies that are publicly traded on the New York Stock Exchange (NYSE) and the NASDAQ. When defining these companies as the “largest,” we are referring to the market capitalization, or market cap, of each company. This is essentially the total value of the company as dictated by the number of outstanding shares and the publicly traded value of each share. The SPX has some unique characteristics that cannot be found in other stock indices. For example, the Dow Jones Industrial Average includes 30 equally weighted stocks. This means that each stock value contributed an equal portion to the total value. The SPX, however, is capitalization-weighted. This means that companies with a larger market cap contribute a greater portion to the total value of the index. Because of this, the SPX is often thought of as a symbol of activity in the economy as a whole because it provides a more accurate representation of how the largest companies are performing.
Another point to remember is that there are not “shares” of SPX in the same way there are shares of SPY. The SPX is an index measure, and there is no way to define values per share. Instead, the investors looking to trade the SPX can use options on futures contracts. Strike prices are determined by the total value of the index itself. Calls benefit from rising values in the S&P 500, and puts benefit from falling values in the index. Since the SPX is the S&P 500 index itself, there are no differences between the value of the SPX and the S&P 500 in the way there will be differences in the SPY.
Key Differences to Not
When comparing the SPY and the SPX, there are some key differences that should be noted:
- SPX does not pay dividends, SPY pays dividends quarterly
- SPX options follow the European format, which means that the option cannot be exercised before the expiry date. SPY options follow the American format, which means that the option can be exercised before the expiry date.
- Settlements for SPX options are conducted using cash values, while options in SPY are settled in shares.
- Options in SPY are much smaller in value when compared to SPX options. A single option in SPX is valued at roughly 10x the value of an option in SPY. So, for example, an option in SPX might trade at $2,000 while an option in SPY might trade at $200.
- In terms of commissions charges, options in SPX are cheaper than options in SPY. If you trade larger volumes at a time, SPX offers some advantages here but it is important to remember that you will be forced to operate under the European system (which offers reduced flexibility when compared to the American options trading system).
In these ways, options traders have a few different choices when investing in the S&P 500. Trends in this index tend to dictate what happens in many other markets around the world. So, it is important to have an understanding of this benchmark (and the ways it trades) even if you do not plan to take direct positions in any of these instruments.
Understanding Options Greeks: Delta and Gamma
One of the terms most commonly associated with options trading deals with the “Greeks.” And while this might sound like exotic terminology, options Greeks can actually help you to better assess the risks associated with your positions. Options Greeks can help traders to know which options should be traded, and when to trade them. In this area, there are five key terms that should be understood: Delta, Gamma, Theta, Vega, and Rho.
This is not an exhaustive list of all the options Greeks, but these are the main choices that are used in options trading. For the purposes of this article, we will be looking at the first two choices on this list, Delta and Gamma. To summarize, each Greek is associated with a specific advantage and usage:
- Delta allows options traders to gauge the probability that your trade will close in-the-money
- Gamma allows options traders to estimate potential changes in Delta when there are fluctuations in the price of the underlying asset
Next, we will look at these Greeks in greater detail so that options traders can apply these ideas to active trading.
The first Greek typically encountered by options traders is Delta, which measures the rate of change in option prices relative to the price of the underlying security. Option Delta fluctuates in a range from 0 to -1 for puts and 0 to +1 for calls. The exact Delta value is a reflection of increases or decreases in the option price after the price of the asset changes by one Dollar. If the option Delta is near zero, the option is deeply out-of-the-money. If the option Delta is near one, the option is deeply in-the-money.
It is possible for Delta to change after very small movements in the price of the underlying asset. Because of this, it can be very useful to understand up Delta values and down Delta values. For example, let’s assume you are trading in call options for a stock with a Delta of 0.5. The Delta of 0.5 might increase by 0.6 points if the underlying stock were to increase by one Dollar, and decrease by 0.4 points if the price of the stock falls by one Dollar. This would mean that the up Delta is 0.6, while the alternative down Delta would be only 0.4.
Time is also an important factor that must be taken into consideration. While holding an option, the time until contract expiry grows closer. As this occurs, the time value of the option decreases, which means the Delta of an in-the-money option increase. By contrast, the Delta of options that are out-of-the-money will decrease. This can be seen in the chart below for a stock priced at $60 per share:
Chart Source: Wikipedia
This chart shows how Delta changes for options using three different expiration periods: one month, three months, and six months. Shorter-term options (blue line) will see a more drastic decline in Delta values while options with a longer-term expiration period will see a more gradual decline in Delta (green line).
Volatility is another important factor. If volatility is rising, the time value for the option will also increase. When this occurs, Delta for in-the-money options will decrease. Delta for out-of-the-money options will increase. Consider the chart below:
Chart Source: Wikipedia
Here, again, we have a Delta chart for a stock that trades with a share price of $60. This chart shows how the Delta of an option relates to the volatility of the stock traded using both calls and puts. Remember, call options are associated with positive Delta (0 to +1) while put options are associated with negative Delta (0 to -1). But, in both cases, Delta falls as market volatility rises.
Gamma in an option is expressed as a percentage and it measures the rate of change in Delta for each $1 fluctuation in the underlying asset price. Delta changes over time, so Gamma is useful because it shows options traders the amount option Delta will change as the value of the underlying asset rises and falls. To use an analogy from physics, Delta can be thought of as speed where Gamma can be thought of as acceleration. Typically, Gamma is at its highest levels when the underlying asset is trading close to its strike price. Gamma decreases when the option moves away from the strike price (in either direction).
As an option’s expiration time comes closer, Gamma for at-the-money options will rise. When the option is in-the-money or out-of-the-money, Gamma will fall. Consider the following chart showing the relationship between time to contract expiration and Gamma values:
Chart Source: Wikipedia
Here, we can see how Gamma changes for options contracts with three different expiration times. Clearly, the model here shows much larger changes in Gamma for options contracts with shorter expiration times, while contracts with longer periods have a much smoother progression.
Volatility levels are also influential. As volatility decreases, at-the-money options will experience rising Gamma. When the option is deep in-the-money or out-of-the-money (ie. prices are moving away from the strike price), Gamma moves closer to zero. As volatility increases, Gamma is usually stable for all strike prices. These factors are illustrated in the chart below:
Chart Source: Wikipedia
Here, we can see that Gamma rises during periods of low market volatility. The reverse is true for assets which are experiencing larger changes in market valuation.
Understanding Options Greeks: Theta, Vega, and Rho
In the previous section, we outlined some of the specifics of options Greeks Delta and Gamma. These are important trading elements that can impact the price of an options contract, and these are terms that should be understood by those looking to establish active positions in the market. For the purposes of this article, we will be looking at the next three choices on our original Greeks list: Theta, Vega, and Rho.
To summarize, each is associated with a specific advantage and usage:
- Theta allows options traders to assess the value an options contract might lose as it comes closer to its expiry time.
- Vega allows options traders to assess potential sensitivity in an option is there are significant price changes in the underlying asset.
- Rho allows options traders to assess the potential effects changes in interest rates could have on the profitability of an options contract.
Next, we will look at these Greeks in greater detail so that options traders can apply these ideas to active trading.
In options, Theta measures the time decay of the trading contract. Options contracts lose time value as they come close to the expiry time — and Theta provides a means for traders to understand just how much value is being lost as this occurs. In most cases, Theta is shown with negative numbers because it is an expression of how much the option value will fall each day. This is why Theta values are close to 0 for longer-term options — they do not lose much of their value each day.
By extension, Theta values are much higher for options contracts taken on shorter-term time frames (especially when they are at-the-money). At-the-money options have the highest time value, so there is greater potential for loss each trading day. Theta can rise significantly as options come closer to expiration because this is when time decay is at its fastest rate. Theta is also elevated for options that are tied to high-volatility assets (which means Theta is lower for low-volatility assets). Time value premium is higher on options tied to high-volatility assets, so there is greater potential for loss on a daily basis. This can be seen in the chart below:
Chart Source: Wikipedia
This chart shows the relationship between volatility and option Theta. Higher Theta values are associated with the 40% volatility asset, when compared to the 20% volatility asset
Option Vega measures the way changes in market volatility influence options prices. In other words, option Vega shows the change in option prices for every 1% variation in the volatility of the underlying asset. For the most part, option prices increase as volatility increases. So any time volatility is on the rise, the price of the option will likely rise as well. If volatility is declining, the option price will likely drop. So, in practical usage, traders looking to calculate options prices will add Vega values when volatility is increasing, and subtract those values when volatility is declining.
Time values are also important when assessing Vega influence. Vega values are higher when there is more remaining time until option expiry. This should not be surprising because time value contributes more to premiums in long-term options, and time value is what is influenced by volatility fluctuations.
Chart Source: Wikipedia
In the above chart, we can see how option Vega changes for contracts using three different time intervals. Levels are highest for the options contract with the nine-month expiration time, smallest for the contract with the three-month expiration time.
Last, we look at Rho which measures changes in option prices for every 1% change in interest rates. Rho values are useful because they allow investors to assess how much option prices will rise or fall when there are changes in the base rates for Treasury bills. When there are increases in interest rates, there are usually increases in the value of call options. When interest rates increase, there are usually decreases in the value of put options. Because of this, positive Rho is associated with call options while negative Rho is associated with put options.
Of all the options Greeks discussed in these tutorials, Rho is the least commonly used. This is because Rho is not typically a significant factor in determining the price of an option. But it is still important to understand Rho because it becomes more impactful in environments where interest rates are expected to change. This is why Rho tends to get more attention in the options trading community right before a major central bank meeting is scheduled to take place.
Similarly, the rest of the options Greeks tend to be more important in different types of market environments. Some of the Greeks are more commonly used than others, but when you have an understanding of each of the major reforms, you will be able to use them in order to assess how the price of an option is likely to change going forward.
At this stage, it should be relatively clear that one of the biggest advantages of options trading is their ability to help investors control risk. At their very core, options contracts allow the buyer of the contract to transfer investment risk to the seller of the option. It is true that options buyers must pay a premium for this added protection. But when used appropriately, these costs are mitigated by both the potential for gains and by the reduction of possible losses.
In this way, options can almost be thought of as an insurance policy for financial investors. For example, when buying call or put options, investors can guarantee the value of an investment at a set date in the future. This is not something that can be said for most other forms of investment, so the analogy to an insurance policy not not unwarranted. But there are other, more advanced, strategies that take this level of protection a step further. These strategies are more commonly referred to as option spread strategies — and they can be incredibly useful in circumstances where market volatility is becoming increasingly volatile and unpredictable. Here, we will discuss some of the specifics involved when trading options spreads and highlight some of the benefits they offer when compared to more basic options strategies.
Options Spread Example
One of the biggest risks encountered when selling options is the theoretically unlimited potential for loss if markets move in the wrong direction. This is one of the reasons beginning traders are usually encouraged to avoid selling options. But it is possible for options sellers to gain added protection from significant losses when implementing the hedging advantages that come with spreads trades. Let’s take a look at an example of how these trades work.
Let’s assume you sell an option to buy 100 shares of XYZ stock in three months at $50 per share. If the stock prices rises to $70 during that period, the option buyer will exercise the option, and you will be obligated complete the transaction. This would equate to losses of $2,000, less the amount of money you received when you sold the option ($20 stock gains x 100 shares).
To help mitigate these potential losses, you could have entered into a spread position. Imagine that when you sold the call option in XYZ stock for $50, you also bought a call option in XYZ stock for $55 over the same period. This might seem like an unproductive activity. After all, why would anyone buy and sell a call option in the same stock? It might seem as though you should only sell the rights to buy a stock if you believe its value will fall in the future. But when we watch this hypothetical situation play out, the advantages start to become more apparent.
Here are the steps for entering into our hypothetical protective spreads trade:
- Buy 100 share call option in XYZ with 3-month expiry and a strike price of $55
- Sell 100 share call option in XYZ with 3-month expiry and a strike price of $50
The buyer of the call option expect valuations in XYZ to increase over the next three months. Remember, there is nothing to stop the price of this stock from going to $100 or even $1,000. So protect yourself from the potential for unlimited losses you also buy a call option in the same stock at $55. If the value of XYZ rises above $55 over the next three months, the positions will start to offset — every Dollar you lose in the sold call option will be replaced by gains you have made in the purchased call option. In this way, options spreads allow you to hedge your risk and limit your losses to a strictly define amount of money.
Implications for Traders
From this example, we can see some critical implications for options traders. It is important to remember that your decision to purchase the $55 call option in XYZ stock was not based on any bullish expectations. In fact, your ultimate outlook is bearish as you are hoping that XYZ stock falls below $50 and that all of these options expire worthless. In this way, you can collect the money from selling the option and then you simply subtract the costs associated with the purchase of the $55 call option. These costs should be lower because the strike price is farther away from the market. When this occurs, you can make gains on the trade.
The main point to remember here is that spread trading involves the simultaneous purchase and sale of two different options contracts. Gains or losses are determined by the net difference between the two contracts. In the example above, the maximum loss would have been limited to $500 (100 shares of XYZ stock x $5 in contract difference). This is much better than the unlimited loss that could have been seen if XYZ stock began to skyrocket after you sold the call option.
For these reasons, spread options tend to be best-suited for traders with a conservative mindset. Nothing in the financial markets comes for free, and the ability to limit losses also creates an environment where your profits are also limited. But if you are starting your investment strategy from the standpoint of limiting risk, spread options provide an excellent framework for accomplishing your goals. When looking at spread trading strategies, there are many choices that are available for options investors. These will be covered in greater detail in the Advanced Options section.
Hedging with Options
Options investors are typically looking to employ one of two strategies: market speculation or market hedging. Speculation involves that ability to profit from future price movements in the underlying asset. Hedging is very different — but is equally important in terms of the ways it influences price activity in the options market. Speculators are trying to maximize potential profits in all possible moments, while hedgers are looking to limit risk in all possible moments. In terms of trading perspective, these two sides can be thought of as the aggressive traders and the conservative traders. In this way, options trading offers a few different alternatives depending on your investment strategy and tolerance for risk.
But no matter which side of the fence you fall on, hedging is something that should be understood by all market participants because it creates order flows that can change the dynamics of the market at any given time. In order to be profitable in options trading, you must be able to accurately assess the direction that markets will travel in next. This can be a difficult task — and if these assessments are done incorrectly, losses can quickly accumulate. In this article, we will look at some of the ways hedging can help keep your trading account protected during these periods of uncertain market activity.
Advantages of Options Hedging
When options traders implement hedging strategies, they are essentially taking out a financial insurance policy for their investments. This can be useful because there is no way to predict where the market will travel 100% of the time. When market uncertainty increases, hedging strategies allow options traders to offset their market exposure with secondary positions. For example, let’s say that you are a stock investors that has recently purchased 100 shares in an up-and-coming technology company.
You are very bullish on the stock, and you expect its value to rise in the future. But you are also aware of the fact that trends in technology companies can be unpredictable and that many startups fail to live up to their initial expectations. Because of this, you are interested in taking a conservative stance on the stock and hedging your position. To accomplish this, you will need to find an investment with a negative correlation to your tech stock exposure. This essentially means you will need to find an asset that increases in value when your initial investment declines in value. Since your original investment is a long position the stock, an alternative investment with a negative correlation can be found in a put option for the same stock.
A strategy like this might seem like a waste of time. After all, why would anyone take a bullish long position to buy a stock and then establish a bearish put option at the same time? The answer is that this is a strategy that can drastically reduce the amount of risk that can be seen in the original investment. There are two possible scenarios: the price of the stock rise or it will fall. If the stock rises, the original investment will profit and the put option will expire worthless. If the stock price falls, any losses that are seen in the original position will be offset by the gains that are accumulated through the put option. In both cases, the only losses associated with the trade are associated with the cost of the put option. Total gains from rising stock values will be equal to the price increase of the stock value less the cost of the protective put option.
Option Hedges for Producers
In the above example, we can see how options can be used by speculators to protect their positions, reduce risk, and limit the potential for large losses. But there are other factors at work that can influence market prices from another angle. In particular, options are often used by companies at the producer level in order to make item prices more predictable in the future.
Imagine, for example, you run a large orange juice bottling company. Your ability to generate profits will depend heavily on the cost of the oranges that are used to make the final product. If prices rise quickly in an unpredictable fashion, your product margins will start to close and your quarterly profits will start to decline. But there are ways to prevent this from happening, and this is a practice that is common enough to change market prices and create new trends. Let’s go back to the orange juice company example and assume that meteorologists have started to forecast unseasonably warm temperatures that could damage orange crops. A scenario like this would limit the available supply of oranges and drive prices higher.
But if you decided instead to buy call options in orange juice, you could lock-in a lower price in the event that the cold weather front negatively impacts the market. Then, if the price of oranges starts to rise dramatically, any losses encountered in rising product costs would be offset by the gains generated through the purchased call option. This is a relatively common practice amongst companies that are heavily exposed to swings in the commodities markets, so this is a practice that can have a significant influence on price activity and underlying trends that are seen in these areas.
In all of these ways, investors can use options to reduce risk and gain a protective edge in the market. These strategies are typically employed by traders with a more conservative outlook, so if this is the approach you are interested in taking, options can provide some excellent advantages.