The ABCs Of Option Trading & A Couple Simple Trading Tips

The world of investing & trading has been flipped on its head, and the rise of the pandemic trader has brought with it an idea that could be very dangerous. This predication that “stocks only go up” could get those freshman option traders out there in a lot of trouble. When the stock market loses its sentiment-driven high, there could be a sizable correction in the tech sector (and broader market).

I don't want any of you taking an outsized risk on out-of-the-money (OTM) option trades and losing it all…at least not without understanding some of the basics of an option. I'm going to go through some of the ABCs of options trading, including the Greeks and different technical strategies.

The ABCs Of Options

The first thing you need to understand about options is that it is a 100-share contract that gives you the “option” to buy (calls) or sell (put) a specific equity at a predetermined price and timeframe. The contract is priced based on six primary factors: type of option (put or call), volatility, underlying asset price, time till expiration, and interest-rates. The formula for pricing these financial derivatives is a complicated equation called the Black-Scholes model, but you don’t need to understand the formula as much as you need to understand its implications.

One of the biggest things I want to focus on here is implied volatility and its impact on the pricing. The more volatile a stock or ETF is, the higher the premium for the option (both calls and puts). If you are trading a broader ETF option, the volatility premium (aka implied volatility) will be highly correlated with the VIX.

Understanding the difference between in-the-money (ITM) and out-of-the-money (OTM) options is crucial. ITM means that the strike price of a call is below what the stock is trading at today. For a put it is the opposite. ITM options are safer for apparent reasons but get increasingly expensive the further into the money you go. OTM options carry more risk for the option holder and are cheaper the further away from the current trading price it sits at.

The expiration date is also significant, with uncertainty being higher for longer time horizons. So, the further out your options expiration, the more expensive it will get. This premium will continue to drop as you get closer to expiration, explained by Theta, which I will address in more detail further down.

The Greeks

The Greeks include Delta, Gamma, Theta, Vega, Rho. I will discuss the two most important “Greeks” (from my perspective) to focus on when trading options.

Delta-

This is the sensitivity of the option to the underlining asset. The figure shows how much the option will move with the underlying stock (100 shares per contract remember). For example, if delta is 0.39, that means that each dollar move in the share price will impact your option by $39 because it's worth 100 shares. The further into the money an option is, the more closely it follows the underlying stock.

Gamma shows how rapidly delta moves.

Theta-

This is one of the most important concepts to grasp because it is crucial to understanding the real cost of holding an option. Theta effectively measures the daily cost to carry that specific call or put if the underlying equity were to trade sideways. Theta is dictated by the volatility of the derivative stock and how far from expiration this option is. The greater the volatility, the higher the daily cost. The further out the expiration, the lower the daily decay to the option.

If you’re option has a theta of .20 it means that if the stock does nothing that day and closes at the exact same price it opened at the position will have lost $20.

For more color on the Greeks, check out the Zacks article by my cohort David Borun, It's All Greek(s) to Me.

Technical Trading Methods

There are a couple of useful and easy trading patterns that you can apply to time both calls and put trades.

Fibonacci Retracement Levels

I utilize TradingView's drawing tools to trace out my Fib levels. Below you can see how Uber (UBER) has traded almost perfectly with the two separate retracements I drew up.

The chart looks a little messy, but I hope you get the picture from the two retracements. I circled in red where the levels held for resistance and support.

Keep in mind that these levels don't always hold, but if you play around with different stocks, ETFs, and indexes, you will find that Fibonacci Retracements support and resistance can be seen everywhere in the markets. This is due to the increasing number of technically driven algo-driven trades, but I will not get into that today.

Oscillators

Oscillators like the relative strength index (RSI) and a stochastic oscillator can be useful to find if a stock is overbought or oversold based on the current share price compared to a range of historic prices. I utilize these oscillators to scalp short-term trades with options. Equities can be overbought or oversold for long periods, but I have found this useful to backcheck my contrarian trading ideas.

Below is I charted out the Nasdaq 100 ETF (QQQ), illustrating how the oscillators have correctly indicated an overbought and oversold market

Final Thoughts

As you can see with my chart above, we are currently sitting a very overbought level, and I would be cautious with call options or large equity purchases.

These simple trading strategies are useful to backcheck trading ideas and originate them. I have been trading off them since the pandemic started and have made some decent money. I primarily utilize the overbought levels to que when I should buy QQQ puts to hedge my tech-heavy portfolio.

Keep in mind what famous economist Keynes said: “The markets can remain irrational longer than you can remain solvent.”

Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.

Interested in strategies with profit potential even in declining markets? Maybe our Short List Trader service is for you.

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