ETF Trend Trading
ETF Trend Trading Option Basics Part One
Option Basics • Separate Sections 1. Option Basics 2. Pricing 3. The Greeks 4. Types of Option Trades
Option Basics • 1. Understanding Options – What is an Option? – The Option Contract – Buying and Selling – Option Premium – Credits vs. Debits
Option Basics What is an Option? • What is an option? • An option is a contract to buy or sell a specific financial product known as the underlying instrument • For Equity Options ( what we will be dealing with) the underlying instrument is a – Stock or – ETF
Option Basics The Option Contract • The Contract - Is very precise 1. It establishes a specific price at which the contract may be exercised – The “Strike Price” 2. It has an “Expiration Date” – when an option expires it no longer has value and no longer exists – Your rights go away on this date if not exercised – Your obligations will be enforced on this date if your option is In-theMoney 3. It has a price or “Premium” you pay or receive 4. It specifies the Number of contracts purchased or sold
Option Basics Types of Options • Basic Options come in two forms: – Calls Options – Puts Options
Option Basics • You can you do with options: 1. Buy and sell Calls 2. Buy and sell Puts 3. Combine the “buying and selling” of “puts and calls” with each other (or with their underlying stock , ETF or Index) to form many different trading strategies 4. Let them expire (worthless) 5. Let them get exercised
Option Basics Buying and Selling • Buying an option ( Call or put) gives you rights. • Selling an option ( Call or put) leaves you with obligations. • The rights and obligations are guaranteed so you never have to worry about who the other party is.
Option Basics Buying and Selling
Buyer
Seller
Call
If you are a call buyer If you are a call seller You have “Rights” You have “Obligations” A C but no rights
Put
If you are a put buyer If you are a put seller You have “Rights” You have “Obligations” but no rights B D
Option Basics Buying and Selling • Your “rights” as a call buyer A – Buy a specific quantity of the underlying – By a certain date ( expiration date) – At a specific price ( strike price) – You pay the seller a premium for this right • You have the right to sell your call to another buyer before expiration • You have the right to exercise your call • You have the right to let it expire worthless
Option Basics Buying and Selling • Your “rights” as a put buyer B – Sell a specific quantity of the underlying – By a certain date ( expiration) – At a specific price ( strike price) – You pay the seller a premium for this right • You have the right to sell your put to another buyer before expiration • You have the right to exercise your put • You have the right to let your put expire worthless
Option Basics Buying and Selling • Your “obligations” as a call seller
C
– Sell a specific quantity of the underlying – By a certain date ( expiration) – At a specific price ( strike price) – You receive a premium ( credit) for this
• This is also often referred to as “writing” a call • You can buy the call back on the open market • You can let it expire worthless
Option Basics Buying and Selling • Your “obligations” as a put seller
D
– Buy a specific quantity of the underlying – By a certain date ( expiration) – At a specific price ( strike price) – You receive a premium for this
• This is also often referred to as “writing” a put • You can buy the put back on the open market • You can let it expire worthless
Option Basics Option Premium • Option Premiums – When you buy an option the purchase price is called the premium – When you sell an option the premium is the amount you receive – The premium price is not fixed and changes just as frequently as the stock or ETF price
Option Basics Option Premium • Option Premium – has 2 parts 1. Intrinsic Value – the amount an option is ITM 2. Extrinsic Value (Time Value)- the total premium minus the Intrinsic Value. The longer the amount of time remaining to expiration the higher the Extrinsic value and the higher the Premium value
Option Basics Option Premium • If you buy options you pay a “Premium” and start with a “net debit” – You have spent money from your account that you may never get back – You can then sell your option for a profit or recover part of your debit and limit your losses (or) – You can exercise your option – They can expire worthless
Understanding Options Option Premium • If you sell options you pay a “Premium” and start with a “net credit” – You receive or collect a premium – You can then sell your option ( for a profit or loss) – If the option is never exercised you get to keep the money but – If the option is exercised • You still get to keep the credit but • You are obligated to buy (or sell) the underlying stock or ETF
Option Basics Option Premium
Buyer
Seller
Call
A debit is charged to your account (you pay a Premium for this) ( you pay money for this)
A credit is charged to your account (you receive a premium for this) ( you receive money for this)
Put
A debit is charged to your account (you pay a Premium for this) ( you pay money for this)
A credit is charged to your account (you receive a premium for this) ( you receive money for this)
You need to understand this concept thoroughly
Option Basics Putting the Pieces Together
Buyer
Seller
Call
The right ( not the obligation) to : 1. Buy a specific Quantity 2. By a certain date (expiration) 3. At a specific price (strike price) 4. A debit is charged to your account ( you pay money for this)
The obligation to : 1. Sell a specific quantity 2. By a certain date (expiration) 3. At a specific price (strike price) 4. A credit is placed into your account ( you receive money for this)
Put
The right ( not the obligation) to : 1. Sell a specific Quantity 2. By a certain date (expiration) 3. At a specific price (strike price) 4. A debit is charged to your account ( you pay money for this)
The obligation to : 1. Buy a specific quantity 2. By a certain date (expiration) 3. At a specific price (strike price) 4. A credit is placed into your account ( you receive money for this)
Option Basics Putting the Pieces Together
Buyer
Seller
Call
What can you do after you buy? 1. Sell (Close) it for a profit 2. Sell (Close) for a loss 3. Let it expire for no value (for a loss) 4. Exercise it
What can you do after you sell? 1. Buy (Close) it for a profit 2. Buy (Close) it for a loss 3. Let it expire for no value (for a profit)
Put
What can you do after you buy? 1. Sell (Close) it for a profit 2. Sell (Close) for a loss 3. Let it expire for no value (for a loss) 4. Exercise it
What can you do after you sell? 1. Buy (Close) it for a profit 2. Buy (Close) for a loss 3. Let it expire for no value (for a profit)
Option Basics In The Money vs. Out of The Money • The Language of Options – In The Money (ITM) – At The Money (ATM) – Out of the Money (OTM) • ATM is when the Market Value of the underlying is at the same as the Strike Price of the Option – this does not occur often and therefore we will not discuss it
Option Basics In The Money vs. Out of The Money
In the Money
Out of the Money
Call
A Call Option is In The Money (ITM) if the current market value of the underlying is above the exercise (strike) price of the option
A Call Option is Out of The Money (OTM) if the current market value of the underlying is below the exercise (strike) price of the option
Put
A Put Option is In The Money (ITM) if the current market value of the underlying is below the exercise (strike) price of the option
A Put Option is Out of The Money (OTM) if the current market value of the underlying is above the exercise (strike) price of the option
Option Basics In The Money vs. Out of The Money If the current Market Price is 52 and the strike price of a call option is 50 the Call Option is ITM
53 52
If the current Market Price is 52 and the strike price of a Put Option is 50 the Put Option is OTM
51 Strike Price
50
If the current Market Price is 48 and the strike price of a call option is 50 the Call Option is OTM
49
48 47 Market Price
If the current Market Price is 48 and the strike price of a Put Option is 50 the Put Option is ITM
Option Basics
Buyers
Sellers
Call
Call Buyers: • Only make money if the stock or ETF price goes up and the • Market Price of the Underlying must be above the strike price to have any value
Call Sellers: • Only make money if the price does not go to high and the • Market Price of the stock or ETF is below the strike price.
Put
Put Buyers: • Only make money if the stock or ETF price goes down • Market Price of the Underlying must be below the strike price to have any value
Put Sellers: • Only make money if the price does not go to low and the • Market Price of the stock or ETF is above the strike price.
Option Basics Primary Risk of Options • Primary Risk of Options – a primary risk you encounter with all options is time risk because option contracts have a limited life (they expire) • Stocks and ETF’s do not expire unless the company ceases to exist or the ETF is closed out by the managing firm
Option Basics • Option Advantages – By controlling rights to the stock rather than the stock itself – you significantly reduce your risk
• Option Risks – Biggest risk is time risk – You have the potential to lose all of your investment ( when buying) if the move you were expecting is too small or too slow
Understanding Options • The Two Basic Truths of options ( ETF Options) – All options have value – All options expire
Option Basics • Separate Sections 1. Option Basics 2. Pricing 3. The Greeks 4. Types of Option Trades
Option Basics • 1. Understanding Options – What is an Option? – The Option Contract – Buying and Selling – Option Premium – Credits vs. Debits
Option Basics What is an Option? • What is an option? • An option is a contract to buy or sell a specific financial product known as the underlying instrument • For Equity Options ( what we will be dealing with) the underlying instrument is a – Stock or – ETF
Option Basics The Option Contract • The Contract - Is very precise 1. It establishes a specific price at which the contract may be exercised – The “Strike Price” 2. It has an “Expiration Date” – when an option expires it no longer has value and no longer exists – Your rights go away on this date if not exercised – Your obligations will be enforced on this date if your option is In-theMoney 3. It has a price or “Premium” you pay or receive 4. It specifies the Number of contracts purchased or sold
Option Basics Types of Options • Basic Options come in two forms: – Calls Options – Puts Options
Option Basics • You can you do with options: 1. Buy and sell Calls 2. Buy and sell Puts 3. Combine the “buying and selling” of “puts and calls” with each other (or with their underlying stock , ETF or Index) to form many different trading strategies 4. Let them expire (worthless) 5. Let them get exercised
Option Basics Buying and Selling • Buying an option ( Call or put) gives you rights. • Selling an option ( Call or put) leaves you with obligations. • The rights and obligations are guaranteed so you never have to worry about who the other party is.
Option Basics Buying and Selling
Buyer
Seller
Call
If you are a call buyer If you are a call seller You have “Rights” You have “Obligations” A C but no rights
Put
If you are a put buyer If you are a put seller You have “Rights” You have “Obligations” but no rights B D
Option Basics Buying and Selling • Your “rights” as a call buyer A – Buy a specific quantity of the underlying – By a certain date ( expiration date) – At a specific price ( strike price) – You pay the seller a premium for this right • You have the right to sell your call to another buyer before expiration • You have the right to exercise your call • You have the right to let it expire worthless
Option Basics Buying and Selling • Your “rights” as a put buyer B – Sell a specific quantity of the underlying – By a certain date ( expiration) – At a specific price ( strike price) – You pay the seller a premium for this right • You have the right to sell your put to another buyer before expiration • You have the right to exercise your put • You have the right to let your put expire worthless
Option Basics Buying and Selling • Your “obligations” as a call seller
C
– Sell a specific quantity of the underlying – By a certain date ( expiration) – At a specific price ( strike price) – You receive a premium ( credit) for this
• This is also often referred to as “writing” a call • You can buy the call back on the open market • You can let it expire worthless
Option Basics Buying and Selling • Your “obligations” as a put seller
D
– Buy a specific quantity of the underlying – By a certain date ( expiration) – At a specific price ( strike price) – You receive a premium for this
• This is also often referred to as “writing” a put • You can buy the put back on the open market • You can let it expire worthless
Option Basics Option Premium • Option Premiums – When you buy an option the purchase price is called the premium – When you sell an option the premium is the amount you receive – The premium price is not fixed and changes just as frequently as the stock or ETF price
Option Basics Option Premium • Option Premium – has 2 parts 1. Intrinsic Value – the amount an option is ITM 2. Extrinsic Value (Time Value)- the total premium minus the Intrinsic Value. The longer the amount of time remaining to expiration the higher the Extrinsic value and the higher the Premium value
Option Basics Option Premium • If you buy options you pay a “Premium” and start with a “net debit” – You have spent money from your account that you may never get back – You can then sell your option for a profit or recover part of your debit and limit your losses (or) – You can exercise your option – They can expire worthless
Understanding Options Option Premium • If you sell options you pay a “Premium” and start with a “net credit” – You receive or collect a premium – You can then sell your option ( for a profit or loss) – If the option is never exercised you get to keep the money but – If the option is exercised • You still get to keep the credit but • You are obligated to buy (or sell) the underlying stock or ETF
Option Basics Option Premium
Buyer
Seller
Call
A debit is charged to your account (you pay a Premium for this) ( you pay money for this)
A credit is charged to your account (you receive a premium for this) ( you receive money for this)
Put
A debit is charged to your account (you pay a Premium for this) ( you pay money for this)
A credit is charged to your account (you receive a premium for this) ( you receive money for this)
You need to understand this concept thoroughly
Option Basics Putting the Pieces Together
Buyer
Seller
Call
The right ( not the obligation) to : 1. Buy a specific Quantity 2. By a certain date (expiration) 3. At a specific price (strike price) 4. A debit is charged to your account ( you pay money for this)
The obligation to : 1. Sell a specific quantity 2. By a certain date (expiration) 3. At a specific price (strike price) 4. A credit is placed into your account ( you receive money for this)
Put
The right ( not the obligation) to : 1. Sell a specific Quantity 2. By a certain date (expiration) 3. At a specific price (strike price) 4. A debit is charged to your account ( you pay money for this)
The obligation to : 1. Buy a specific quantity 2. By a certain date (expiration) 3. At a specific price (strike price) 4. A credit is placed into your account ( you receive money for this)
Option Basics Putting the Pieces Together
Buyer
Seller
Call
What can you do after you buy? 1. Sell (Close) it for a profit 2. Sell (Close) for a loss 3. Let it expire for no value (for a loss) 4. Exercise it
What can you do after you sell? 1. Buy (Close) it for a profit 2. Buy (Close) it for a loss 3. Let it expire for no value (for a profit)
Put
What can you do after you buy? 1. Sell (Close) it for a profit 2. Sell (Close) for a loss 3. Let it expire for no value (for a loss) 4. Exercise it
What can you do after you sell? 1. Buy (Close) it for a profit 2. Buy (Close) for a loss 3. Let it expire for no value (for a profit)
Option Basics In The Money vs. Out of The Money • The Language of Options – In The Money (ITM) – At The Money (ATM) – Out of the Money (OTM) • ATM is when the Market Value of the underlying is at the same as the Strike Price of the Option – this does not occur often and therefore we will not discuss it
Option Basics In The Money vs. Out of The Money
In the Money
Out of the Money
Call
A Call Option is In The Money (ITM) if the current market value of the underlying is above the exercise (strike) price of the option
A Call Option is Out of The Money (OTM) if the current market value of the underlying is below the exercise (strike) price of the option
Put
A Put Option is In The Money (ITM) if the current market value of the underlying is below the exercise (strike) price of the option
A Put Option is Out of The Money (OTM) if the current market value of the underlying is above the exercise (strike) price of the option
Option Basics In The Money vs. Out of The Money If the current Market Price is 52 and the strike price of a call option is 50 the Call Option is ITM
53 52
If the current Market Price is 52 and the strike price of a Put Option is 50 the Put Option is OTM
51 Strike Price
50
If the current Market Price is 48 and the strike price of a call option is 50 the Call Option is OTM
49
48 47 Market Price
If the current Market Price is 48 and the strike price of a Put Option is 50 the Put Option is ITM
Option Basics
Buyers
Sellers
Call
Call Buyers: • Only make money if the stock or ETF price goes up and the • Market Price of the Underlying must be above the strike price to have any value
Call Sellers: • Only make money if the price does not go to high and the • Market Price of the stock or ETF is below the strike price.
Put
Put Buyers: • Only make money if the stock or ETF price goes down • Market Price of the Underlying must be below the strike price to have any value
Put Sellers: • Only make money if the price does not go to low and the • Market Price of the stock or ETF is above the strike price.
Option Basics Primary Risk of Options • Primary Risk of Options – a primary risk you encounter with all options is time risk because option contracts have a limited life (they expire) • Stocks and ETF’s do not expire unless the company ceases to exist or the ETF is closed out by the managing firm
Option Basics • Option Advantages – By controlling rights to the stock rather than the stock itself – you significantly reduce your risk
• Option Risks – Biggest risk is time risk – You have the potential to lose all of your investment ( when buying) if the move you were expecting is too small or too slow
Understanding Options • The Two Basic Truths of options ( ETF Options) – All options have value – All options expire
