The Unlucky Investor's Guide to Options Trading guides readers through the world of options and teaches the crucial risk management techniques for sustainable investing.
A type of corporate action that occurs when one company purchases a majority stake in another company. Acquisitions can be paid for in cash, stock, or a combination of the two.
A short option, regardless of whether it’s a call or put, can be assigned at any time if the option is in the money. When selling a put, the seller is contractually giving the right for the put owner to sell or “put” them stock at a given price (Strike Price) in a given set of time (expiration). Selling a call gives the right to the call owner to buy or “call” stock away from the seller within a given time frame. The purchaser of an option has the right to exercise an in the money option at any time prior to expiration, but not necessarily the obligation to do so. Short options are most commonly assigned if the options expire in the money, or if there is a dividend paid out (Dividend Risk).
A pessimistic outlook on the price of an asset. Traders who believe that an asset price will depreciate over time are said to be bearish.
A Broken Wing Butterfly is a long butterfly spread with long strikes that are not equidistant from the short strike. This leads to one side having greater risk than the other, which makes the trade slightly more directional than a standard long butterfly spread.
A 3-strike price spread that profits from the underlying expiring at a specific price.
Expected move is the amount that a stock is predicted to increase or decrease from its current price, based on the current level of implied volatility for binary events.
A calendar spread is a low-risk, directionally neutral strategy that profits from the passage of time and/or an increase in implied volatility.
Correlation is the relationship between two or more variables with a range of negative (-1) to positive (+1). It is generally measured on a historical basis with a minimum of one month. Correlation measures the rate at which two stocks have historically tended to move in relation to their mean. If they are normally on opposite sides of the mean, they tend to move in opposite directions and have a negative correlation. If they are normally on the same side of the mean, they tend to move in the same direction and have a positive correlation. If there is no clear trend, they are said to have little to no correlation (0). Understanding correlation allows us to diversify our portfolio in non-correlated underlyings.
A Covered Call is a common strategy that is used to enhance a long stock position. The position limits the profit potential of a long stock position by selling a call option against the shares. This adds no risk to the position and reduces the cost basis of the shares over time.
Day trading is the opening and closing of your trading positions within a short period, typically the same day. Also known as intraday trading, the goal of using this trading style is usually to take small profits which eventually add up to bigger gains over time.
A Diagonal Spread is constructed by purchasing a call/put far out in time, and selling a near term put/call on a further OTM strike to reduce cost basis. The trade has only two legs, but it gives the effect of a long vertical spread in terms of directionality, and a calendar spread in terms of its positive vega.
A dividend is a cash distribution, usually quarterly, to shareholders based on company profits. Investors that own the stock receive the dividend. Investors that are short the stock are required to pay the dividend. Dividends are non-events from a P/L basis. When dividends are paid, the stock price is reduced by the amount of the dividend so that no arbitrage opportunity exists. With that said, it is still important to know when a dividend is coming out, to see if your option position is at risk.
An investing/trading methodology that estimates a security’s fair value using relevant quantitative and qualitative information. The goal of this approach is to compare the result of fundamental analysis to the current market value of a security to determine whether it is undervalued, overvalued, or fair.
Options on futures are similar to options on stocks, but with one major exception…Futures are the underlying instrument off which the options are priced (unlike equity options which have the stock as its underlying). As a function of being priced off of futures, it’s important to be aware of the differences between futures options and equity options.
Gamma is the greek that gives us a better understanding of how delta will change when the underlying moves. It is literally the rate of change of an option’s delta, given a $1.00 move in the underlying. For example, if a long call option has a gamma of 0.10 and a delta of 0.50, and the underlying moves up $1.00, the option will then have a delta of 0.60, all else equal. There are a few important concepts when it comes to gamma: Long option benefits, short option risks, and expiration risk.
A metric which tells us whether implied volatility is high or low in a specific underlying based on a given time frame of IV data.
Implied volatility (commonly referred to as volatility or IV) is one of the most important metrics to understand and be aware of when trading options. Implied volatility in the stock market refers to the implied magnitude, or one standard deviation range, of potential movement away from the stock price in a year's time.
An Iron Condor is a directionally neutral, defined risk strategy that profits from a stock trading in a range through the expiration of the options. It benefits from the passage of time and any decreases in implied volatility.
An Iron Fly is essentially an Iron Condor with call and put credit spreads that share the same short strike. This creates a very neutral position that profits from the passage of time and any decreases in implied volatility. An Iron Fly is synthetically the same as a long butterfly spread using the same strikes.
A Jade Lizard is a slightly bullish strategy that combines a short put and a short call spread. The strategy is created to have no upside risk, which is done by collecting a total credit greater than the width of the short call spread.
Legging a trade refers to the opening or closing of each leg for a non-naked strategy in separate transactions.
Liquidity is how easily an investor can buy or sell an asset without losing much value. The more an asset is traded, the more liquid it becomes.
A long butterfly spread is a neutral position that’s used when a trader believes that the price of an underlying is going to stay within a relatively tight range.
The term “managing winners” refers to closing a trade prior to expiration and prior to max profit.
Margin is the amount of capital required to open a trade.
Market awareness refers to our ability to assess the entire stock and option marketplace from a macro level. Having a better market awareness allows us to avoid poor decisions and optimize our good ones. We like to break market awareness down in three levels: Sector awareness, fear awareness & participant awareness.
Mean reversion is very important to what we do at tastytrade. As mean reversion traders, we look to exploit price extremes and volatility because we believe they will revert to their mean over time. Volatility proves to be the one variable that is recognized as being ‘mean reverting’ in many option-pricing models.
Measuring implied volatility (IV) with a few metrics enables traders to put context around current and historic IV levels. At tastytrade, we focus on two measurements - IV Rank & IV Percentile.
Short “naked” options are calls or puts that are sold that have nothing to limit their risk (shares of stock, long options). It is a bullish strategy when selling a put option and a bearish strategy when selling a call option.
The notional value of a position is the real amount at risk, excluding margin relief. If we own 100 shares of stock at $50.00 per share, we have $5000 of notional value at risk. If the stock price drops to $0.00, we stand to lose $5000. In a margin account, we are offered 2:1 leverage on stock purchases. What does this mean? Basically, that same 100 shares of stock would only require $2500 of capital to purchase. What we have to remember is that we still have that same $5000 of notional value. In other words, we only have to put up $2500 at first, but if the stock price goes to $0.00 we still lose $5000.
When it comes to probabilities, we have to understand that there are winners and losers. Even if we have a 99% probability of success on a trade, one percent of those trades will still be losers over a very large pool of occurrences. Let’s say that we reach our true probability over 1000 occurrences. We could expect to see 990 winners and 10 losers. The question is - where will those 10 losers occur? Nobody knows, and that’s the importance of trading small.
Allocating a minimum of $2,000 to a trading fund.
One of the Greeks, delta measures the rate of change in an option’s theoretical value for a $1 change in the price of the underlying security.
Where an option gets its price can seem like smoke and mirrors when first learning about option trading, but it is actually pretty simple. Option value, also known as option premium, is really just made up of two contributing factors - intrinsic & extrinsic value. These values change based on three inputs: strike price in relation to the stock price, implied volatility, and time until expiration. That’s it! We won’t leave you there though - let’s dive a little deeper and start with intrinsic value.
The date at which an option stops trading, and all contracts are exercised or become worthless. Expiration is one of the differentiating factors between stocks and options. As long as a company is publicly traded, there is no expiration on shares. Options, on the other hand, have expirations.
A "Poor Man’s Covered Call" is a Long Call Diagonal Debit Spread that is used to replicate a Covered Call position. The strategy gets its name from the reduced risk and capital requirement relative to a standard covered call.
A “Poor Man’s Covered Put” is a Put Diagonal Debit Spread that is used to replicate a Covered Put position. The strategy gets its name from the reduced risk and capital requirement relative to a standard covered put. The strategy is also much safer than a covered put because there is no naked short stock component.
Probability of profit (POP) refers to the chance of making at least $0.01 on a trade. This is an interesting metric that is affected by a few different aspects of trading - whether we’re buying options, selling options, or if we’re reducing cost basis of stock we are long or short.
A term referring to the current bid/ask price of an asset in the marketplace.
A front ratio spread is a neutral to slightly directional strategy placed so that there is either no upside or downside risk. A Front Ratio Spread is created by purchasing a put or call debit spread with an additional short put or call at the short strike of the debit spread.
Risk Management refers to the strategic risk that we take when trading options. This covers everything from our trade size, to our strike selection, product choice and type of strategy. We are able to control all of these factors in order to increase our probability of success and avoid large drawdowns in our account.
Rolling a trade is one way to manage a winning or losing position.
In statistics, standard deviation (SD) is a unit of measurement that quantifies certain outcomes relative to the average outcome.
While traditional investing advocates for fewer occurrences and values the buy and hold strategy, we at tastytrade take a statistical approach to trading. We believe in putting on many small high probability trades to increase our probability of success.
A short straddle is a position that is a neutral strategy that profits from the passage of time and any decreases in implied volatility. The short straddle is an undefined risk option strategy.
A short strangle is a position that is a neutral strategy that profits when the stock stays between the short strikes as time passes, as well as any decreases in implied volatility. The short strangle is an undefined risk option strategy.
A strike price is the price in which we choose to become long or short stock using an option. Unlike stock where we’re forced to trade the current price, we can choose different option strikes that are above or below the stock price, that have different premium values and probabilities of profit. When choosing strikes, there are a few crucial concepts: The probability of the option expiring worthless, and whether the option is in the money (ITM), at the money (ATM) or out of the money (OTM).
Theta is the daily decay of an option’s extrinsic value. This metric is the cloudiest of all, as it assumes implied volatility & price movement are held constant. For this reason, it’s better to think of theta decay from the bigger scheme of things.
Triple witching refers to one of the four days a year when index futures, index options and stock options expire on the same day.
Undefined Risk refers to the risk that is accompanied with naked options and when your possible max loss is unknown on order entry. This normally refers to a naked call as the underlying equity could possibly go up indefinitely. Naked puts also have undefined risk, however we know that an underlying can only go to zero so we can consider this our max loss.
The idea that the movement of the /VX give some type of prediction of future market activity.
One of the Greeks, vega measures the rate of change in an option’s theoretical value given a 1% change in implied volatility.
A vertical debit spread is a defined risk, directional options trading strategy where we buy an option that we want to increase in value, while selling a similar option type against it to reduce the overall cost and risk of the trade.
“Vertical” in this case just means that the options are in the same expiration cycle.
“Debit” means we are paying for the spread, and we want the overall spread to increase in value. The long option is our asset in a debit spread, and the short option is our cost basis reduction component.
“Spread” indicates that we have a long and short option component in the same trade, where one offsets the P/L of the other to a degree.
A vertical spread is a directional strategy made up of long and short puts/calls at different strikes in the same expiration. Vertical spreads allow us to trade directionally while clearly defining our maximum profit and maximum loss on entry (known as defined risk).
The ZEBRA (zero extrinsic value back ratio spread) is a near-100 delta stock replacement strategy with all of the upside profit potential with a fraction of the risk compared to owning 100 shares of stock. It is constructed by purchasing two ITM (in-the-money) options and selling one same-style ATM (at-the-money) option against it to eliminate all of the extrinsic value in the two long options you’re buying.
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