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Options Basics

Getting started in options: Forget ‘the Greeks’?

Most traders are well aware of the economic problems facing Greece related to debt – one day it looks like default, the next day the can has been kicked down the road with a temporary fix. But we are not into bashing the Greeks or writing off Greece as a viable market in this article.

Instead, we are talking about “the Greeks” related to options – delta, theta, gamma, vega and all the rest.

We don’t want to belittle the usefulness of these Greek readings because they obviously have great value for the options trading wizards and gurus who use these statistical measures to evaluate options movement and risk, and we don’t want to sound too options illiterate. But for many beginning options traders, the Greeks really do sound like Greek to them – too academic.

Options are a great trading instrument because they offer so much flexibility. But scare stories and warnings frequently cause traders to shy away because they perceive options as being too confusing and too risky, even requiring special permission from brokerage firms to use them. If you are interested in getting into options, you need to focus on only a few things:

    • Where are prices of the underlying market headed, based on whatever market analysis you use (fundamentals, charts, whatever)? Everything starts with the underlying market.

    • Depending on the current price of the underlying market, do you want to be long or short at that strike price reference point? (Note we did not say buy or sell because you can do either to express a point of view in options.)

    • A “call” gives the buyer the right, but not the obligation, to be long at a given strike price. A “put” gives the buyer the right, but not the obligation, to be short at a given strike price. How much would you pay – the “premium” – for the right to be long or short at the strike price, based on the price movement you expect the underlying market to make?

    • The option seller plays the opposite role, being obligated to provide a position at the strike price. How much premium would you have to receive to entice you to take on the risk of providing someone else with a position at a given strike price?

    • How volatile is price action in the underlying market? Volatility is a crucial factor in options. You can get an idea by looking at the length of price bars or candles or you can refer to an overall measure like the Volatility Index (VIX) for stocks.

  • How liquid is the option – in other words, how easy is it to get into or out of a position without slippage? Two factors can be a helpful guide: Volume in the options contract being considered (ideally, 1,000 or more per day) and tightness of the bid/ask spread.
  • Is the potential return of an options position worth the risk? Always think risk first.

Several other words of advice for trading options:

  • If volatility is higher than average, look at selling an option. Yes, that can be the scary side of options as it opens up the potential for unlimited risk. But the majority of options expire worthless, and the seller gets to keep the premium.
  • If volatility is less than average, suggesting a quiet, complacent market, look at buying an option. Your risk is limited to the premium paid, but the underlying market price does have to move beyond the strike price for you to make a profit.
  • You can use options to buy below the current market price. If the price of a stock is at 20, for example, and you would like to buy at 18, you can sell a naked 18 put. WARNING: Do not sell more naked puts than the amount of shares that you and your account are willing and able to buy. One put is 100 shares; 100 X 18 is $1,800. If you sell 10 puts to take in more premium, you run the risk of having to buy 1,000 shares for $18,000 at options expiration.
  • You can use options to produce incremental income on a market you own or are willing to buy at the current price. You own a stock at 18; sell a covered call at 20. If the market reaches 20, you may have the shares called away from and you can take the profit. If the market does not reach 20, you keep the premium and can sell another 20 call in a later month (or weekly with the newer weekly options). You can also sell naked calls but . . . read the warning above and then read it again.
  • Selling is where much of the danger in options trading occurs. You can mitigate the risk with various options spreads.

Some of the above may still sound like Greek to you, but hopefully it makes options trading a little clearer than trying to understand Greek statistics.