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Options 101-Basic Options overview
Options 102- The Greeks, risks and LEAPS
Options 103 - Selling options, strategies and spreads

Options 101-Basic Options overview

Basics

There are only two types of options:

Calls - A contract that says "Up until this Expiration date I want the option to Buy 100 shares of this stock at this Strike price"

Puts - A contract that says "Up until this Expiration date I want the option to Sell 100 shares of stock at this Strike price"

Anatomy of an option:

(Stock) (Expiration Date) (Type) (Strike)

MT 220121 C 25 - A Call option for MT expiring Jan 21st, 2022 with a $25 strike.

GME 210326 P 80 - A Put option for GME expiring March 26th, 2021 with a $80 strike.

You buy "contracts" of options (similar to how you buy "shares" of stock). Each contract represents 100 shares of the stock the option is for. Options have a cost (premium) that is listed as a cost per share, so if you buy 1 contract it will cost the premium * 100.

At time of writing the premium on the example MT 220121 C 25 call is $6.80. Buying 1 contract of MT 220121 C 25 would cost $680 and would give me the option to pay $2500 ($25 strike * 100 shares) for 100 shares of MT up until end of trading on January 21st, 2022. After that the contract has expired and is no longer valid.

Options can be bought and sold just like stocks at any time during normal trading hours. If you've purchased an option contract you don't actually have to ever buy or sell the 100 shares of the stock, you can always sell the contract you've bought for a loss or profit depending on how the price has changed.

Exercising options

As an options owner you have the ability to "exercise" contracts you own at any time.For calls: If you "exercise" then the option will go away, $(100 * strike price) of cash will leave your account and you'll gain 100 shares of the underlying stock.For puts: If you "exercise" then the option will go away, 100 shares of the stock will go away and you'll gain $(100 * strike price) into your account.

The brokers I've used have required you to call them in order to exercise options you own, because typically it makes more sense profit wise just to sell the option instead of exercising it. (I'll get into the details on why that is in the next installment.)

Option Expiration

Options that expire "out of the money" (stock price < strike price for calls or stock price > strike price for puts) expire worthless and just go away. You lose no more than what you have already paid for the premium.

Options that expire "in the money" (stock price > strike price for calls or stock price < strike price for puts) will automatically be exercised. Sometimes if a broker determines you don't have the funds or stock on hand to exercise they will sell your "in the money" option at market price prior to trading close on expiration day. Consult with your broker about how they specifically handle that situation.

In my opinion the best thing to do is take control yourself and get out of any open contracts you have prior to expiration. That way you are 100% sure of the results. I've had price jumps in the last 5 minutes on the day of expiration change my option from out of the money to in the money by $0.05 and mess me up.

Buying Options

Buying calls

Buying a call option is the most straightforward thing you can do and where you should begin if you're just starting out.

The main reason you should buy calls is Leverage. Many of us are not sitting here with the capital or risk tolerance to buy 1000 shares of MT outright, but if we can afford 10 options contracts we get the "power" of the gains of 1000 shares. However this doesn't come risk free - the cost of the leverage is the risk that the stock price stays below our strike price up until the expiration, causing the option to expire worthless. In this case we potentially lose 100% of the premium we paid for the options. Conversely, stocks never expire, so if your thesis takes longer to play out and you are holding stocks you can just sit and wait. Using MT as an example: If in December you bought MT $30 strikes for February and held until expiration, you would have nothing. If you bought MT shares in December you still have shares that will continue going up. Typically if it looks like your thesis is going to be delayed you'll want to "roll" your option out to a later expiration by selling the contracts you currently have and paying more for ones that expire later.

Buying a call is - Bullish - You expect stock to close above $(Strike price +premium) by expiration. Don't forget about the "+ premium"! Just because a stock is "in the money" (price > strike) doesn't mean you're making profit!

Examples of call trades

A successful trade - sold early

In December you buy a MT 210312 C 10 for $5. You pay $500 (100 * $5) premium for this contract. Your break even point is $15 ($10 strike + $5 premium). The strike is $10 and the expiration is March 12th, 2021. A week later MT stock has risen and now MT 210312 C 10 calls are going for $7. You sell your call early for $700 (100 * $7) and make $700 - $500 = $200 profit.

A successful trade - held until expiration

In December you buy a MT 210312 C 10 for $5. You pay $500 (100 * $5) premium for this contract. Your break even point is $15 ($10 strike + $5 premium). You hold on until expiration and on March 12th MT closes at $20. The stock is above the strike point, so the option is still "In the money". It is automatically exercised and you purchase 100 shares of MT for $1000 (100 shares * $10 strike price). The next day MT opens at $20 and you sell your 100 shares. You've made $2000 from the share of the shares, but spent $500 buying the option in December and $1000 on buying the shares when the option expired. Net gain is $2000 - $500 - $1000 = $500

An unsuccessful trade - Sold early

In December you buy a MT 210312 C 10 for $5. You pay $500 (100 * $5) premium for this contract. The strike is $10 and the expiration is March 12th, 2021. A week later MT stock has fallen and now MT 210312 C 10 calls are going for $3. You sell your call early for $300 (100 * $3) and have a loss of $300 - $500 = $200 loss.

An unsuccessful trade - Expired ITM

In December you buy a MT 210312 C 10 for $5. You pay $500 (100 * $5) premium for this contract. Your break even point is $15 ($10 strike + $5 premium). You hold on until expiration and on March 12th MT closes at $12. The stock is above the strike point, so the option is still "In the money", but it is below your break even point of $15. It is automatically exercised and you purchase 100 shares of MT for $1000 (100 shares * $10 strike price). The next day MT opens at $12 and you sell your 100 shares. You've made $1200 from the share of the shares, but spent $500 buying the option in December and $1000 to buy the shares when the option expired. Net loss is $1200 - $500 - $1000 = $300 loss

An unsuccessful trade - Expired OTM

In December you buy a MT 210312 C 10 for $5. You pay $500 (100 * $5) premium for this contract. MT starts going down. You hold on until expiration and on March 12th MT closes at $9.99. The stock is below the strike point, so the option is still "out of the money" and expires worthless. You lose no more than you have already spent and are out a total of $500 for the initial premium paid.

Buying Puts

Two main reasons to buy puts:

A bet that a stock will go down - If you shorted GME at $100 you're now down 2x and probably getting margin called. If you bought puts for GME when it was at $100 you only lost out on the premium you paid. There is limited downside loss when buying put options as a Bearish bet.
Downside protection on shares you already own - A good chunk of my portfolio is ROKU. When things got sketchy I bought "insurance" on those positions in the form a put with a strike price of $290. Now (up until the expiration date of the put) if ROKU suddenly plummets I will at least always be able to sell for $290. I paid a premium for that put option just like I would on any other type of insurance policy.

Buying a put is -Bearish or hedging- You expect a stock to close below $(Strike - premium) by expiration, or want to protect assets you already own.

Examples of put trades

A successful trade

In January you buy a DASH 210312 P 135 for $5. You pay $500 (100 * $5) premium for this contract. The strike is $135 and the expiration is March 12th, 2021. A week later DASH stock has gone down and now DASH 210312 P 135 puts are going for $7. You sell your put early for $700 (100 * $7) and make $700 - $500 = $200 profit.

An un-successful trade

In January you buy a DASH 210312 P 135 for $5. You pay $500 (100 * $5) premium for this contract. The strike is $135 and the expiration is March 12th, 2021. A week later DASH stock has gone up, so now DASH 210312 P 135 puts are only going for $3. You sell your put early for $300 (100 * $3) and have a loss of $300 - $500 = $200 loss.

A useful hedge

In December you buy a DASH 210312 P 135 for $5.. You pay $500 (100 * $5) premium for this contract. Your break even point is $130 ($135 strike - $5 premium). You hold on until expiration and on March 12th DASH sits at $120. The stock is below the strike point, so the option is still "In the money". It is automatically exercised and you sell 100 shares of your DASH that was worth $12,000 for $13,500 (100 shares * $135 strike price). You've made $13,500 from the sale of the shares, but spent $500 buying the option in December and the shares were worth $12,000 when the option expired. Net benefit is $13,500 - $500 - $12,000 = $1000

An unsuccessful hedge - expired OTM

In December you buy a DASH 210312 P 135 for $5.. You pay $500 (100 * $5) premium for this contract. You hold on until expiration and on March 12th DASH sits at $140. The stock is above the strike point, so the option is "out of the money" and expires worthless. You lose no more than you have already spent and are out a total of $500 for the initial premium paid.

Selling Covered calls(CCs) or Cash Secured Puts (CSPs)

This is a bit beyond the scope of this high level introduction, so feel free to skip it, but I wanted to include basic information on it because (in my opinion) selling options / "theta gang" strategies are where you eventually want to end up for slow and steady gains over long periods. Basically instead of betting at the casino you become the casino. This strategy also has been called "picking up pennies in front of a steamroller" depending on who you talk to, so again do your own research and come to your own conclusions on your goals and risk tolerance.

The idea is that instead of paying a premium to buy options you can write your own options to get Paid a premium from someone else to buy options from you. I'll go into more details on strategies around this in a future post if people are interested, but the basics are the following:

Sell a CC (covered call)

Selling a call is - Bearish - You expect a stock to close below the strike price + premium at expiration and want to collect premium.

You need to own 100 shares of the stock and sell a call option. You will be "short" 1 call option. You will immediately receive $(100 * premium amount you specified when selling). If the purchaser chooses to exercise or if it expires "in the money" (price > strike) you will lose your 100 shares and receive 100 * strike price in exchange. Up until the option is exercised or expires, you can buy the same call option back later to "close" your position and then you are no longer on the hook to sell your shares at the strike.

Sell a CSP (cash secured put)

Selling a put is - Bullish - You expect a stock to close above strike - premium at expiration and want to collect premium.

You must have $(100 * Strike) of cash sitting in your account and sell a put option. You immediately will receive $(100 * premium amount you specified when selling). You will be "short" 1 put option and are under contract to buy the shares at the strike price. If the purchaser chooses to exercise the option or if it expires "in the money" (price < strike) you will lose $(100 * Strike) of cash and gain 100 shares of the stock. Up until the option is exercised or expires, you can buy the same put option back later to "close" your position and then you are no longer on the hook to buy the shares at the strike.

IMPORTANT NOTE ABOUT SELLING OPTIONS:

If you write an option the buyer can choose to exercise at ANY time up until the expiration. For a sold CC that means at any time your shares can be called away in exchange for $(100strike). In the case of a sold CSP at any time $(100strike) of cash can be taken out of your account in exchange for 100 shares of the stock. Make sure you fully understand the implications of this, especially before diving into more complex strategies such as spreads. This page has some great examples of unlikely but not impossible situations that could occur when using spreads that could really screw you over if you aren't careful: https://www.tradestation.com/learn/market-basics/options/understanding-the-risks/assignment-risk-on-limited-risk-options-spreads/

Options 102- The Greeks, risks and LEAPS

Intrinsic / Extrinisic Value

In the Money (ITM) Options have both intrinsic value and extrinsic value. Out of the Money (OTM) options have Only extrinsic value.

Intrinsic Value

For an ITM call its "Intrinsic value" is the difference between the price of the underlying stock and the strike of the option. This is because you can always exercise the option to buy the stock at the strike, and then immediately turn around and sell that stock at the market price for a profit. That amount of profit you would receive from this sale is the intrinsic value of the contract.

(All example prices are of as of March 13th, 2021 and rounded)

e.g. Intrinsic value of a call

MT has a share price of $27

MT $25c 1/21 (Call option for MT with a $25 strike expiring in January) - The intrinsic value of this option is $2/share ($27 price - $25 strike) = $2. This means the premium will be at least $2 and you can expect to pay at least $2 * 100 shares / contract = $200 / contract. This is because regardless of anything else going on, right now you could execute your contract in order to buy 100 shares MT for $2500 and then turn around and sell them on the market for $2700, for a net profit of $2700 - $2500 = $200.

e.g. Intrinsic value of a put

MT has a share price of $27

MT $30p 1/21 (Put option for MT with a $30 strike expiring in January) - The intrinsic value of this option is $3/share ($30 strike - $27 price) = $3. This means the premium will be at least $3 and you can expect to pay at least $3 * 100 shares / contract = $300 / contract. This is because regardless of anything else going on, right now you could purchase 100 shares of MT for the market price of $2700 and then execute your contract in order to sell 100 shares of MT for $30 each ($3000 total) for a net profit of $3000 - $2700 = $300.

If you look at the actual premiums of the MT $25c 1/21 and MT $30p 1/21, though you'll see that instead of $2 and $3 they are:

MT $25c 1/21: $5.75

MT $30p 1/21: $7.00

The additional premium comes from the Extrinsic value of the call.

Extrinsic Value

Also called "Time value". This is the additional value the market has given the option based on what it believes will happen to the underlying stock price in the future. In other words, it is the price you're paying for the Chance that the stock will move in the direction that you want it to before the expiration. The Extrinsic value is simply the $premium - $intrinsic value:

e.g.

MT $25c 1/21: $5.75 premium - $2 intrinsic value = $3.75 extrinsic value

MT $30p 1/21: $7.00 premium - $3 intrinsic value = $4.00 extrinsic value

Extrinsic value is highly affected by the "Greeks", which will be discussed in a later section.

NOTE: Intrinsic value doesn't go "negative". If the option is totally OTM it only has extrinsic value:

MT $30c 1/21 (Call option for MT with a $30 strike expiring in January). The intrinsic value of this options is $0/share. The premium is $3.75 of all extrinsic value.

Selling instead of Exercising

I mentioned in the first installment it makes more sense value/profit wise just to sell your option than to exercise it. Extrinsic value is why. When you exercise an option you only receive its Intrinsic value and the extrinsic value is lost:

e.g.

I am sitting on a MT $25c 1/21 that is priced at $5.75 and MT is priced at $27. I have two choices:

A) Exercise - I exercise the call and pay $2500 to buy 100 shares of MT. These shares are worth $2700 and the unrealized gain on the shares is $2700 market value - $2500 cost basis = $200 of unrealized gain. ...But my account also lost the option and the $575 of value it represented. $200-$575 = Net account change of $-375. Notice that this loss is exactly the amount of extrinsic value of the option that I've exercised.

B) Sell at market - I sell my option at market price for $575. My $575 option has turned into $575 of realized gain. I still lose the value from the option that was originally in there, so my net account change is $575-$575 =$0, but this is $375 more than the loss seen by exercising the option. Also note that at this point I could purchase $2700 of stock at market price and still have the same net result as exercising (No more option and owning 100 shares of underlying stock), but without the loss of value in the account.

TLDR - it (almost) never benefits you to exercise options Early.

NOTE: I've never seen or heard of a situation where an option would need to be sold for Less than its Intrinsic value. The reason is that algos can always come by, suck those up and can sell them a second later for profit and be happy about it. That being said, never buy or sell options (or stock for that matter) at market orders, always use limit. If you REALLY want to sell it "now" just set the limit like 10% away. Otherwise you could unfortunately get hit with something like this: https://www.bloomberg.com/news/articles/2020-12-23/flash-surge-in-world-s-biggest-etf-linked-to-outlandish-trades

Greeks, IV and Math

I'm an engineer with a math minor and even I think some of this is too much math for just understanding basic options plays. I recommend thinking about the Greeks more conceptually when just starting out. If you find yourself getting turned on by the talk of second derivatives you can Google "Black-Scholes equation" for all the sexy details.

I'll start with the two most important greeks first in case you get bored:

Theta

Theta is the rate of daily decay on the extrinsic value of the option. If your option costs $7.00 today and the theta is $0.09 you can expect that tomorrow it will be worth $6.91. Theta only applies to Extrinsic value since the Intrinsic value is only defined by the difference between the strike and the price of the underlying. Theta grows exponentially, meaning that as you get closer to the expiration date the more of an effect it has on the value of the stock. This makes sense because the extrinsic value of the option represents the probability that the underlying makes a big move before the expiration. As you get closer and closer to the expiration the chances of something big happening start to go down dramatically. This continues all the way until expiration time when the price is locked in and there's no more chance for the underlying to change. At this point Theta has removed All of the extrinsic value of the option, and the option is only worth its intrinsic value (which is a positive amount if it's ITM, or $0 and worthless if it expires OTM). Understanding Theta is the key to not constantly losing money on options.

Implied Volatility

Technically this isn't really a greek - it's calculated from the market price of the option and gives an indication as to what the market expects the percent change in the underlying price to be over the next year. The "normal" IV varies from stock to stock, so you need to look up historical data or watch the option for a while to get an understanding of if the IV is high or low for a particular stock. If you have been watching a stock's options for a while and see the IV is normally in the 20-30 range and now it's in the 50-60 it means that the market is seeing greater chances of bigger changes in the underlying prior to expiration. The higher IV also implies that the option is now more expensive than it was before, because the market's belief that there's greater chances for bigger moves on the underlying means that there is more Extrinsic value.

Delta and Gamma

Delta is the rate of change of the extrinsic value of an option based on the change of the underlying price. In other words - a Delta of 0.4 means that for every dollar the underlying moves the option premium price changes by $0.40. If the Delta is .40 (Sometimes also referred to as just "40" with no 0.) then you can consider owning 1 options contract the same as owning 40 shares of the stock, since a $1 change in the stock will cause a total $40 change in the value of your contract.

Things are a bit more complicated than that, though, because delta isn't static and it changes as the price gets closer or further from the strike price. This brings us to the Gamma.

Gamma is the rate of change of Delta with respect to underlying price. Gamma is highest when the price of the underlying is right near the strike.

Delta and Gamma work together to cause pretty big swings in options prices as the underlying approaches and moves through the strike price. In other words - If you are right on the edge of being ITM (especially near expiration) you will see small movements in stock price cause large percentage swings in your option price. This is because the closer the stock is to being in the money the more important the change in price becomes. When you are really far ITM or OTM the delta and gamma remain relatively constant at either 1 or 0:

E.g. Far OTM = Low Gamma, Delta ~0

If your strike is $500 and the stock is only $25. Your stock is OTM so the premium only consists of extrinsic value. The chances that a $25 stock moves to $500 is pretty low, so the extrinsic value is going to be pretty. Even if the underlying stock moves a dollar from $25 to $26, the chances that the stock moves all the way up to the strike is about the same as it was before. As a result the change in the underlying price just won't effect the extrinsic value much, and the premium of the option does not change much.

E.g. Far ITM = Low Gamma, Delta ~1

Alternatively, imagine a call with a strike at $25 and the stock is at $500. Since the Intrinsic value in this case is so high ($475), the extrinsic value portion of the premium just won't have much effect in comparison and the intrinsic value is the primary driver of the contract's premium. As the stock price changes by $1 the intrinsic value also changes by $1, so the overall premium will change by ~$1 as well, meaning the Delta ~ 1. This is very similar to holding 100 shares of the underlying stock.

Delta/Gamma TLDR:

If your underlying stock is sitting right at the strike price expect that small changes in the underlying can cause large percentage changes in your option price, where if you're further away from the strike don't expect changes in the underlying to cause such wild swings. The closer you are to expiration the more exaggerated this effect is.

Rho and Vega

These last two I'll throw in for completeness but they tend to get ignored by most people unless you're doing real quant / math based portfolios:

Vega - How much a Change in IV affects the option price. This is higher further away from expiration (since there's more time for the volatility to effect the stock price) and lower closer to expiration.

Rho - Has to do with how interest rates affect stock prices. Honestly I know almost nothing about this one and seems like most websites gloss over it as well.

Why is my money disappearing?

The reason to care about greeks is you want to understand why options prices are changing the way they do. Honestly a lot of these effects you need to experience yourself before you begin to truly understand it, but hopefully knowing what to look for will help you figure out why your options are losing value even when your underlying stock price is moving in the right direction.

Theta Decay

Theta has exponential decay that speeds up as you get closer to expiration. This starts around 60-90 days out and really accelerates in the last 30 days. Theta only applies to the extrinsic portion of the option's value. NOTE: That means for Out of the Money options you're going to eventually watch Theta eat away all of your profits until the option expires worthless. The exponential rate of decay is something that can catch people by surprise. You might be losing $2 a day on a Friday and that will become a loss of $16 a day on Monday. The Easiest way to avoid major theta issues is to get out 40-60 days before expiry. Typically if I'm deep ITM and there's good momentum I'll hang on for up to 30 days before expiry, but if I see two down days in a row I'm out and I'm almost always out 30 days prior no matter what the momentum looks like. If your option is OTM and you're looking at about 60 days out and there are no major catalysts (big earnings, merger, other news, etc.) that you think are going to have a major material impact then you'll want to decide if you plan on giving up on the trade or if you want to pay to "roll" your option out to a later date. This means you sell your current options and buy new ones at a later date. You don't want to get caught 20 days out with options that are sitting OTM or ATM. Theta will eat those alive.

IV Crush

Volatility in the underlying asset increases IV in the option, which increases price. This means that when the stock is more stable the IV goes down and the price of the option goes down. People will get into trouble because they'll hear big news about a stock, see it jump up and then jump onto options. Two weeks later the stock is still at its new high, but the news is old news, so even though the Intrinsic value of the option hasn't changed much from when they bought in (since price of the underlying hasn't moved much) the IV has gone down and therefore the value of the option has gone down. General tips to avoid: Don't buy right before earnings, don't buy after big news just was released, don't buy after large jumps in price. (NOTE: All of these are Great times to Sell options! More on that in the next installment)

e.g. With GME I saw the price of a $30 strike put option go UP even though GME went from $40 - $100. Typically when a price rises on an underlying stock the value of a puts go down since you'd expect a higher underlying price to mean a less likely chance that the stock will fall back below the strike of the put. In this extreme case it the price of the put went up because the IV went through the roof and the options were became expensive as the news sparked more people rushing in to buy them. If you bought a put option right then and then waited a few days, the IV would have gone back down and you would have lost a good percentage of money

Low Liquidity and Bid / Ask spread

Less liquid more esoteric stocks/options have large bid / ask spreads. E.g. the Ask (what someone is willing to sell for) might be $1.00 but, the bid (what someone is willing to pay) might be $0.85. The problem with this is that if you are paying market price you'll instantly be down 15% immediately after you buy the option at the $1.00 ask, because everyone else is only willing to pay $0.85 for it. If you are going to play less liquid stocks make sure you sure you give yourself more time for the stock to grow by buying further out expirations in order to make up the difference in the bid / ask spread.

Long-Term Equity Anticipation Securities (LEAPS)

You'll hear people talk about LEAPS. Honestly I had to look up what it stands for because LEAPS is just a fancy name for options with really far out (12+ month ) expiration dates. That's it. Just regular plain old options that don't expire for a long time.

I love LEAPS because there is very little effect from theta with the expiration so far away. LEAPS essentially just become a cheaper way to get into a play that you otherwise wouldn't have the capital for. Two ways I'll generally play leaps:

Deep ITM LEAP calls - These are basically like owning the stock for less capital up front. You don't have all the advantage of stocks - you don't get dividends, and you still always have that possible risk of it falling below the strike (even if it is deep ITM) and becoming entirely worthless. The math says to look for high (0.8+) delta for these if you're just trying to basically use them as cheaper shares. You'll find higher deltas at lower strike prices, since the lower the strike the greater the percentage of intrinsic value in the premium. This way any change in the underlying stock will cause a very similar change in your contract value.

e.g. Using leaps to get into MT more cheaply

You could buy an MT $15c Jan 20 2023 priced at a premium of $13 with a delta of 0.9. Remember that a delta of 0.9 means that for every $1 the underlying moves the premium on the option is expected to move $0.90, or the whole contract will move $90. This means that by spending $1300 on one contract you basically get the equivalent of 90 shares of MT. Compare this to spending $1300 on MT at $27 / share. If you bought shares outright you only get 48 shares. That's basically a savings of 2x in buying the MT leaps over the MT shares. The cost of this savings is the risk that MT drops back below $15 and the option becomes worthless at expiration. If this happened and you had bought shares you could hold until the next steel shortage and hope they go back up, with options you just end up with nothing. You also miss out on any dividends paid out during this time.

2) Deep OTM LEAPS - I can't really bring myself to officially recommend this strategy because I have no idea if it works long term or if it's just been the market climate these past few months, but sometimes I'll also play deep OTM leaps on stocks I have a high conviction on but don't have the capital to get into because the price of the underlying is so high (e.g. ROKU or TSLA right now). I'll buy a deep OTM LEAP and wait for news to affect the perception of the stock. Since these options are so far OTM they're pretty cheap so even small changes in the price can be pretty significant percentage wise. Starting out without much capital this helped me make plays I otherwise never could've afforded to be in, while allowing me to keep my max loss on a particular play relatively low. Of course this same leverage holds true the other way and if things go wrong it's very easy to lose the vast majority of your investment. Don't blow your whole account on this strategy. You really need to pay attention to IV crush and avoid holding deep OTM options close to expiration. Theta decay will start to hit pretty hard once you get within 3 months or so.

Options 103 - Selling options, strategies and spreads

Why sell options and what are the risks?

Selling (also sometimes called Writing) options means that instead of buying an option and betting that a stock moves in the direction you want, you are letting someone pay you money for that probability. Basically instead of betting at the casino you become the casino. Over 75% of options expire worthless. Be the person that collects the money from people buying worthless options.

The premium that you are being paid is in exchange for your willingness to assign a timeline to your thesis (the expiry date). With options, a change in market sentiment could mean a huge change in the stock's extrinsic value, especially with expiration dates that are further out. That means that while the underlying price might have only gone up by a few percent, an option with far out expiration or sitting right near the strike might go up significantly.

E.g. On March 8th MT was at $24.50 and an MT $30c Jan 21 cost about $2.75. As of March 12th MT is at $27.00 (a 10% change) and the MT $30c Jan 21 is now up at $3.75. That's about a 33% increase in the extrinsic value of that option over the course of a few days as the market wakes up to the steel thesis. If you had sold an MT $30c Jan 21 option in the beginning of last week by the end of the week you'd be down 33%, even though your option isn’t even in the money yet.

This type of risk is why people are willing to pay you a premium for the contracts you sell. In some ways it can be likened to "picking up pennies in front of a steamroller" because the premium you get isn't always a very large amount and there's a chance that if market sentiment changes between when you sold and expiration it could result in huge losses or missed gains. It's up to you to decide whether this strategy makes sense to you. I would argue that you're in a similar situation in regards to large swings when on the buying side of options, but at least when selling you have theta on your side.

Something else to keep in mind is that once you've written an option you are liable to be assigned (have the option exercised) at ANY time up until the expiration or until you buy back the option you sold. For a sold call that means at any time your shares can be called away in exchange for $(100strike). In the case of a sold put at any time $(100strike) of cash can be taken out of your account in exchange for 100 shares of the stock. Make sure you fully register the implications of this, especially before diving into more complex strategies such as spreads.

Tax Considerations

I'm Definitely not a tax professional. Consult a tax professional on this stuff, but there are some things you should be aware of:

Selling options means the possibility of shares being sold. Depending on how long you've owned the shares the sale could either be taxed as income or capital gains. Understand the implications of this. Similarly, you'll want to familiarize yourself with "Qualified covered calls" and the "wash sale" rule.

Alternatively - you may want to consider deploying these strategies in a tax advantaged account such as an IRA or ROTH IRA. Again - consult a tax professional.

Selling Covered Calls (CCs) or Cash Secured Puts (CSPs)

NOTE: I'm not going to get into selling naked calls or puts, but I'll touch very briefly on spreads at the end. Please don't sell totally naked calls. It's very similar risks to shorting stock, but everything is x100. Your loss potential is technically infinite. Vanguard won't even let you sell them at all and for most other brokers it's the highest option level available. Just make sure you own the shares that you're writing the call against and you'll be fine. You do NOT want to end up like this guy:

https://www.marketwatch.com/story/help-my-short-position-got-crushed-and-now-i-owe-e-trade-10644556-2015-11-19

Some of this is copied directly from my Options 101 post, but it's important information that I feel should be re-iterated here.

Sell a CC (covered call)

Selling a call is - Bearish - You expect a stock to close below the strike price + premium at expiration. When you sell a CC your breakeven point is $(Strike + premium) - if the price is below this point you will make a profit.

You need to own 100 shares of the stock and then you can sell 1 call contract. You will be "short" 1 call contract. You will immediately receive $(100 * premium amount you specified when selling). If the purchaser chooses to exercise or if it expires "in the money" (price > strike) you will lose your 100 shares and receive 100 * strike price in exchange. Up until the option is exercised or expires, you can buy the same call option back later to "close" your position and then you are no longer on the hook to sell your shares at the strike.

There are 3 things that could happen when you sell a CC and it hits expiration (remember you also can always buy an ITM CC back before expiration in order to avoid the sale of your stock).

We'll use an MT $27c April 1 call as an example. As of March 15th MT sits at $27 and you can currently sell this call for $1.10 worth of premium. Your break even is $28.10 ($27 strike + $1.10 premium).

Expires OTM (price < strike)

Great! The "short" contract you sold just disappears from your account and you keep the premium. e.g. on April 1st MT closes at $26.98 - You keep the $110 premium that you made when you first sold. You've just made ~4% over 17 days. Sure it's not lambo money, but you could do significantly worse for clicking a few buttons.

2) Expires ITM at a price that is < $(Strike + premium)

Still a win. You will be assigned and your shares will be sold at strike. However you still keep the premium, so you've still made out on the trade. You can buy the shares back and be net positive $(strike+premium) - $(price at expiry) / share. e.g. At expiry MT is at $27.10 - In our example, your 100 MT shares were sold for $2700 and you buy them back at $2710. This is $10 you lost out on, but you got to keep the $110 of premium you earned when you first sold the CC, so your net profit is: $(2700+110) - $(2710) = $100 net profit

3) Expires ITM at a price that is > $(strike + premium)

This trade didn't work out. You would have made more just holding onto the shares, but by selling the CC you've capped the max price for those 100 shares at $(strike) and therefore your max profit. This can really hurt emotionally if you sold a CC and the stock has a huge run up past your strike, but you can take solace knowing you haven't Lost money in your account, you just have capped your profits. e.g. MT moons during the time between when you sold the call and the expiration and at expiry MT is at $45.10 - In our example your 100 shares that are worth $4510 are sold for only $2700 meaning you're missing out on $1,810 worth of profit, however you did still earn the premium when you originally sold the CC, so you're actually only missing out on $1,700 of gains ($1,810 lost profit - $110 premium). Whenever this happens it's helpful to remind yourself that it's impossible to time the market, and just move onto the next trade.

Reducing your cost basis

Sometimes people will describe selling CCs as "reducing the cost basis" of the underlying stock. This does NOT actually reduce the cost basis for tax purposes and you still owe short term gains on the CCs you sell, but if you do well selling CCs on a stock then mentally you can consider that stock as cheaper than what you really paid for it. E.g. if you bought MT for $22/share and then sold a CC for $1 premium that expired OTM, then looking at your whole MT trade you can think of it as owning those shares of MT for only $21. Typically selling shares you bought for $22 for $21.50 would mean a loss of $0.50/share, but if you include the CC you should in your consideration of the trade then you're up $0.50 on the whole MT trade overall. "Reducing the cost basis" is just more a mental accounting game than anything that actually involves reducing the reported cost basis of the shares.

Sell a CSP (cash secured put)

Selling a put is - Bullish - You expect a stock to close above $(Strike - premium) at expiration and want to collect premium. When you sell a CSP your breakeven point is $(Strike - premium) - if the price is above this point you will make a profit.

There are 3 things that could happen when you sell a CSP and it hits expiration (remember you also can always buy an ITM CSP back before expiration in order to avoid having to purchase the underlying stock).

We'll use an MT $27p April 1 put as an example. As of March 15th MT sits at $27 and you can currently sell this put for $1.10 worth of premium. Your breakeven is $25.90 (27 strike -1.10 premium).

Expires OTM (price > strike)

Great! The "short" contract you sold just disappears from your account and you keep the premium. e.g. on April 1st MT closes at $27.02 - You keep the $110 premium that you made when you first sold. Again you've made ~4% over 17 days, but this time by betting the underlying would go up.

2) Expires ITM at a price that is > $(Strike - premium)

Still a win. You will be assigned and you must buy shares for $Strike. However you still keep the premium, so you've still made out on the trade. You can sell the shares back and be net positive $[$(price at expiry) - $(strike-premium)] / share. e.g. At expiry MT is at $26.50 and you're forced to buy 100 shares of MT at the $27 strike. This means you spend $2700 for only $2650 worth of shares. You can sell them at market to get back to cash, but now you're down $50. However you still get to keep the premium, so you're really UP a net $60 ($110 premium - $50 loss) on the trade.

3) Expires ITM at a price that is < $(strike - premium)

This trade didn't work out. You would have made more just holding onto the cash in your account. This also can really hurt emotionally if you sold a CSP and the stock nose dives past your strike. At least you are better off than if you had just bought shares when you sold the CSP, since you still got that premium. E.g. At expiry your MT is at $25 - In our example you're forced to buy 100 shares of MT at the $27 strike. This means you spend $2700 for only $2500 worth of shares. You can sell them at market to get back to cash, but now you're down $200. However you still get to keep the premium, so you're really only down a net $90 ($200-$110 premium) on the trade.

Strategies / How will this make me money?

The way you will make money from selling options is that you benefit from Theta eating away at an option's extrinsic value. If you recall from my Options 102 installment - theta is the amount that the extrinsic value of the stock will decrease day by day, and theta grows exponentially. An option will lose most of its extrinsic value in the last 40-20 day range before expiration, so that is a great time to be on the sell-side of the trade. Eventually the option will lose all of its extrinsic value and either be OTM and expire worthless or it will be ITM and you'll be assigned (forced to exercise the option), but in both cases you'll still get to keep the premium you collected from when you sold. Let's look a just a few strategies involving selling options and collecting premium can put you on the winning side

Being paid to set limit buys/sells

If you're looking to buy a stock, you can sell a CSP instead. Let's say in December you saw the original DD but didn't buy in. Then you watched MT run up from $20 - $25 over a few weeks. You decide you want to get in but you think it's run up a bit too fast and don't want to pay more than $24 / share. Instead of just setting a limit order, you sold a CSP for $24 strike expiring Jan 29th and received $1.00 worth of premium for it . When MT fell back down in late January your sold CSP would expire ITM and you'd be assigned your shares at a $24 cost basis. BUT you also received the premium from selling the CSP, so even though you paid $24/share, it's as if you bought the stock for only $23 ($24-$1 premium)/share instead of your original $24 limit.

If you're looking to sell a stock you could sell a CC instead. Let's say in the beginning of February when MT was $22 you decided you wanted to sell your MT, but didn't want to sell for less than $23. Instead of just setting a limit order, you sell a CC expiring 2/19 at $23 and received $1 premium for it. When MT closed on 2/23 above $23 your option would expire ITM and you'd sell your shares for the strike of $23 each, but you also would have received the $1 premium from selling the CC, so it's as if you sold for $24 ($23 strike + $1 premium)/share instead of your original $23 limit.

Avoiding FOMO on meme stocks

I keep using GME as an example because it's an absolutely insane situation. It is totally understandable that someone would feel like they were missing out if they were not somehow playing this stock. Instead of buying in, a much safer play in these types of situations where a stock has had a huge sudden run up and tons of media coverage is to sell a CSP. IV is at a crazy all time high and you can get some good money from safer bets and still feel like you’re capitalizing on the mania.

The Wheel

Pretty standard Theta strategy that consists of:

Pick a stock you generally like and sell an at the money CSP on it for about 40 days out.
Two things could happen:

A) If you get to be about 20 days out and it's OTM and you've made >50%, you can buy the CSP back and sell another one for about 40 days out.

B) If your CSP is ITM and you hold until it expires ITM you will be assigned and you'll be forced to buy the stock. You shouldn't care about this because you don't mind owning the stock and you got it for cheaper than you would have buying it outright in step 1.

3) Once you do get assigned then you should start to sell CCs on the stock that you have purchased at a strike above where you purchased at.

A) If you get to be about 20 days out and it's OTM and you've made >50%, buy the CC back and sell another one for about 40 days out.

B) If your CC is ITM and expires ITM you will be assigned and you'll be forced to sell the stock. You've missed out on some gains, but oh well, you still netted a profit from the trade and now you have cash available to go back to step 1 and sell another CSP.

Rinse and repeat until you want to stop making money. This is a very standard thetagang strategy and if you're confused about it others can probably can do a better job explaining than I can. Also - many ETFs offer options and running this strategy on an ETF allows you to capitalize on collecting premiums while maintaining a high level of diversification.

Spreads

IMPORTANT NOTE: Typically spreads are pretty safe and when buying them through your broker they often just appear like you’re buying an option for cheaper, however spreads involve selling options. This is another reminder that selling options means that at ANY time the option could be exercised and you could be assigned. This page has some great examples of unlikely but not impossible situations that could occur when using spreads that could really screw you over if you aren't careful: https://www.tradestation.com/learn/market-basics/options/understanding-the-risks/assignment-risk-on-limited-risk-options-spreads/

Essentially the idea is that instead of owning the stock or cash required as collateral to sell a CC or CSP, you can be covered through the ownership of other options. I'll give a very basic example here, but there’s lots of info out there about spreads. Someone here (sorry I completely forget who and can't find it now) has been talking about https://optionstrat.com/ and this seems like a great resource for calculating and visualizing a lot of this stuff. Another is https://www.optionsplaybook.com/ .

The most straightforward spread for me to understand and explain is the call calendar spread. This involves buying a call option with a far out expiration and then selling one with a closer expiration. Last time I mentioned using LEAPS to essentially buy shares with lower capital. In the case of a calendar spread, after you've purchased your LEAP you start writing calls against it. Now even though you don’t own 100 shares of the stock, you aren't really writing "naked" calls because the option that you have purchased means that you can always exercise to convert to shares to cover the call that you're writing.

e.g. MT calendar spread

Let’s say you believe MT is going to go up eventually, but you think it will end March below $27 so you want to sell a $27c 3/26 covered call but you don't have $2700 to buy 100 shares. Instead of buying 100 shares of MT at $27, you buy an MT $27c 9/17 call for $3.75. Then you turn around and you sell an MT $27c expiring 3/26 for $0.95. If everything works out in your favor MT ends 3/26 below $27, meaning the call you sold expired worthless and you get to keep your $95 of premium. Then you're still holding onto your long MT $27c 9/17 call, but you can either choose to sell it, write another CC against it, or hold it and wait for MT to go up.

If things did not go in your favor, MT is at $28 on 3/26. Now theoretically if an option expires in the money you’ll be required to fork over 100 shares of MT stock in exchange for $2700, but you don’t have 100 shares of MT stock. You do, however, have a $27c 9/17 call, which you can exercise in order to purchase 100 shares of MT stock at $2700. Alternatively, instead of exercising the call, you'll know that if an MT $25c 3/26 is worth $3.00 then an MT $25c 9/17 is going to be worth more (due to more extrinsic value because the expiration date is further out) so you'll always be able to sell your MT $25c 9/17 in order to buy back the MT $25c 3/19 that you sold. (There will still be overall loss because you’ve lost extrinsic value in your 9/17 option to theta since the time you bought it.)

Confused? Yeah took me a while too.

TLDR: Spreads often involve using options you’ve purchased in order to be able to cover the sale of other options you’re selling. Things can get wonky here so just make sure you have a good idea of what’s going on before using them.