November 2021

Bullish vs Bearish and Long vs Short Explained

Posted on November 10, 2021February 14, 2022 by Mike Martin

Last updated on February 14th, 2022 , 10:09 am

There are a lot of new terms that beginner investors must learn. Some of them can be incredibly complicated; others are rather straightforward. This article is going to cover a few of the more straightforward trading terms.

Understanding the difference between bullish vs bearish as well as long vs short is vital. These terms are the building blocks upon which other investing narratives build. Let’s get right into it!

TAKEAWAYS

“Bullish” investors believe prices will rise
“Bearish” investors believe prices will fall
A “Long” position indicates an investor owns a security
A “Short” position indicates borrowed securities. Generally speaking, an investor “short” a security speculates the price will fall.

Bullish vs Bearish

What strange words the investing world uses to describe market direction! But at least they’re named after animals; at least they’re relatively fun.

Before we dive into the meanings of these two words, let’s do a brief history of their origin. Additionally, knowing how these terms came to be may help you remember them.

Origins of Bullish and Bearish

Ever watch a tourist get gored during the running of the bulls at the San Fermin Festival in Pamplona, Spain? If so, remembering what a “bull market” is will be easy for you.

When a bull attacks, the animal thrusts its horns into the air (along with any unsuspecting tourists from Ohio). In other words, the bull’s head goes “up”.

Since there are no “running of the bears” (yet), understanding what “bearish” means may not be as intuitive.

The origin of the term bearish is not as cut and dry. In truth, nobody can say for certain where it comes from. A deep dive revealed the history of the term bearish involved something called “bearskin jobbers”, trappers and medieval brokers. Let’s skip that definition and go on to the easier one, shall we?

A bear attacks by raising its giant paw and swatting prey down. Hopefully, you haven’t learned this empirically. This is how we will remember what a “bearish market” is: downward.

Bullish

The term “Bullish” is a metaphor for an upward trending market. If we are in a bullish market, prices keep going up, just like the body of that tourist. Bullish investors believe the price of a security or securities will rise in value.

Bearish

The term “bearish” is the exact opposite of bullish. A bullish market is a downward trending market. The stock market is considered bearish if the overall prices of stocks are falling.

When the pandemic hit, the market was bearish. When the economy rebounded, it was bullish. Therefore, bear markets are bad for an economy; bull markets are good.

Bullish and Bearish Sentiment

If you spend any time watching CNBC, you’ll hear the word bullish and bearish peppered into every other sentence. We learned before that a bullish market goes up and a bearish market goes down. But what about the future of a market?

If you believe a market is going to go up in the future, you are bullish. If you believe a market is going to go down in the future, you are bearish.

Nobody knows for certain which direction a market (any market at all) will go in the future, but those talking heads on TV sure do like to give their opinion on the matter. This bullish and bearish guessing is called “speculation”.

Market Neutral

Additionally, you can be neither bullish nor bearish. What is the word for this term? Not some sort of crossbred nightmare animal as I wish it were (Beull? Isn’t that a motorcycle?), but simply “neutral”. If you’re “market neutral” you don’t think a market is going to go anywhere at all.

Perhaps the best way to take advantage of a neutral market is with call-and-put options.

So now you can impress (or bore) your friends at the pub next Saturday with some new terms. But what if they fire back some other terms that you don’t understand? What if they say, “So you’re bullish; what exactly are you long?”

So what the heck does “long” mean? I’m 6’2, so I guess I’m long.

Long vs Short

Things get a little more complicated when we are talking about long and short. Let’s take a look at the (potential) origin of these terms so we can understand them better.

Origins of Long and Short

Trying to figure out the origins of long vs short becomes a bit more ambiguous. One theory is that the terms came from a medieval method of record-keeping called “tally sticks”, as seen below.

In old England, accountants of the crown made notches on these sticks to record proof of payment between parties. The stick was then split lengthways into two pieces; a long piece and a short piece. The long piece was then given to the “payer” and the short piece was given to the “seller”. At a later date, the parties would place the pieces together to make sure they fit in a process called “tallying”. This fitting together of the pieces confirmed that a previous transaction had indeed taken place.

I believe the UK Government has since updated its record-keeping methods.

Since the party who received that larger stick paid, they were considered “long’. The party that had the shorter piece of the stick “owed”, and was thus short. This may make the process of separating the two terms easier (or perhaps more difficult) for you.

Long

If you have a “long” position in an asset/security, you own that security. For the most part, if you are long something, you want it to go up in value. However, there are many exceptions to this rule (more on this in a bit).

You can use this term to describe anything you own. On a recent trip home, I remembered I was “long” several thousand baseball cards. Unfortunately, they have not gone up in value.

In the stock market, you can either be long or short stock. If you are long shares of Apple (AAPL), for example, you actually own part of that company. You can even vote on important decisions the company makes in something called a “proxy”. If you are long AAPL stock, you obviously want it to go up in value.

The vast majority of investors are long stocks. An investor who went long $100 worth of stocks within the S&P 500 in the year 1900 would have over $8.5 million today. That’s not a bad return. A lot of that return comes in the form of dividends. If you are long something, you have rights. Short sellers? Not so much.

Short

Selling short is the exact opposite of going long. An investor who shorts a stock speculates that that stock will decline in value.

How do you go about selling something you don’t own? The markets allow participants to borrow shares from a broker while simultaneously selling these shares. An investor who does this will profit when the stock goes down in value.

If the market does indeed decline in value, that investor can buy the shares back for a profit. When an investor buys back their short shares, they simultaneously return the borrowed shares to their broker, and they are “flat”, or have no positions.

Short Selling Example

If this concept sounds confusing (as it did to me when I first learned it) here’s a tangible analogy.

Let’s say your best friend just paid $500 for a new Xbox. Before he opens it, you ask to borrow it. He agrees. You then immediately sell it to someone else for $550.

Your (ex) best friend is upset and demands you replace it. You find a new Xbox on eBay for $500. You buy this Xbox and give it to him, pocketing the $50 in profit.

In a nutshell, that’s short selling. The only difference is that instead of an Xbox, you’re borrowing stock from your broker to sell to someone else – and they know your intentions.

There has been a lot of talk about banning short selling. This would be a mistake (and very unlikely). The ability to sell short is a cornerstone of capitalism. If short sellers didn’t exist, the stock market would rise inexorably before crashing epically.

Just think about what would happen during a debate if you were only allowed to agree.

GameStop and Short-Selling

Short selling has significant risks. You may recall the GameStop (GME) battle of 2021 between Reddit and Wall Street. If you buy a stock at $20 and sell it for $300, you just made $280 a share. Not bad!

However, if you sell shares of GME (as many hedge funds were doing) at $20, and GME rises to $300, you just lost $280/share. The losses precipitate, and what follows is a herd of short-sellers rushing to cover their positions in what is called a “short squeeze”.

When selling short stocks, you can lose a lot more than you invest. When you go long a stock, you can only ever lose 100% percent of your initial investment (assuming the stock goes to zero).

Something called “gamma squeeze” happened on this stock as well. Learn more about this options trading term here, “Gamma Squeeze Explained“.

Short Selling = Infinite Risk

When you short a stock, you have in theory infinite risk, since there is no telling how high that stock may go. This can lead to what is called a “margin call”. This happens when your broker says, “Alright, you lost a lot of money on this short stock; what if the stock continues to go up and you don’t have the funds to cover the losses? Then we’re at risk. We require more money for you to hold the position, or we’re going to liquidate your account.”

In short (no pun intended), just know that if you short a stock, you want it to go down in value. The mechanics can get quite complicated.

So by now you probably think that “long” is synonymous with “bullish and “short” is synonymous with “bearish”: Why aren’t they just the same word?

Sometimes, a long position can actually be bearish, and a short position bullish. Let’s take a look at a few of these exceptions.

Exceptions to the Rule

Chances are that if you’ve heard of GameStop, you’ve heard of options trading as well. Options trading allows investors great leverage in the marketplace. Instead of trading stock, an options trader is buying the right to either buy or sell stock.

There are two types of options contracts; calls and puts:

A “put option contract” is a financial derivative that allows an investor to profit when a stock goes down in value. Put contracts give an investor the right to sell shares of stock at a specific price (strike price) by a certain date (expiration date). Unlike stock, options are contracts, and thus expire over time.

A “call option contract” is a financial derivative that allows an investor to profit when a stock goes up in value. Unlike put contracts, call contracts give an investor the right to purchase shares of stock at a specific price (strike price) by a certain date (expiration date).

If you are “long” a “put contract”, you are betting that the market will go down in value. Therefore, not all long positions are bullish.

Huge profits are made and lost in options trading. If you’d like an introduction to options trading, feel free to check out our free YouTube guide below. Over 10 million YouTubers have already done so!

Option Trading for Beginners

Final Word

The majority of the time, you can equate long with being bullish, just as you can equate short with being bearish. If you’re only talking about individual stocks, you will generally be safe. Some exchange-traded funds (ETFs), however, actually are designed to make money when the market goes down.

For long-term investors, bullish and long is generally the only way to go.

Thanks for reading, and happy trading!

Additional Resources

What is a gamma squeeze – IG

Long and Short Positions – Corporate Finance Institute

What Does “Bullish” Mean in Stock Trading? | The Motley Fool

SPX vs SPY Options: Here’s How They Differ

Posted on November 10, 2021April 29, 2022 by Mike Martin

Last updated on April 29th, 2022 , 10:54 am

Though nearly identical in performance, there is an ocean of difference between the SPDR® S&P 500® ETF Trust (SPY) and S&P 500® Index Options (SPX). It is absolutely vital you understand the different nature of these two products before you place your first options trade.

Perhaps the most obvious difference between these two products is that, unlike SPY, no stock trades on SPX. But there are many more caveats investors must know when comparing the two.

Most professional options traders prefer to trade SPX over SPY. Let’s take a look at a few key differences between these two products to find out why.

TAKEAWAYS

SPX options are settled in the European style.
SPY options are settled in the American style.
European style options do not allow for early exercise.
SPY is settled via an exchange of the underlying security.
SPX is settled via a transfer of cash. This settlement type reduces pin risk.
SPX options offer investors tax advantages.

	SPX	SPY
Style	European	American
Settlement	Cash-Settled	Physical Delivery
Tax Advantages	Has Tax Advantages	No Tax Advantages
Dividend	No Dividend	Issues Dividend

American Style (SPX) vs European Style (SPY)

American style options represent the vast majority of options contracts, including equities and Exchange-Traded Fund (ETF) ETFs such as SPY. This type of option can be exercised at any time prior to expiration. This often complicates matters for options sellers; sellers may in theory be assigned at any time. Option sellers are in particular danger of assignment if the option is in-the-money as the expiration date nears or when a dividend is issued.

European style options contracts, on the other hand, must only be exercised at expiry. SPX options are European styled, as are other indexes, such as Russell 2000 Index Options (RUT) and Nasdaq 100 Index Options (NDX).

But all in-the-money (ITM) options, regardless of how they are styled, will eventually be assigned and exercised. Let’s next take a look at the different ways in which SPX and SPY are settled.

Cash Settled (SPX) vs Physical Delivery (SPY)

Cash-Settlement occurs on European style index options like SPX. In this type of settlement, the actual delivery of the underlying is not required. This should make sense: since there is no underlying stock to trade on SPX, what product will you deliver? You do have to deliver something, however, and that something is a transference of cash.

When an in-the-money cash-settled option expires, the owner of that option (whether it be a long call or long put) will be credited cash. The amount of this cash credit will be the difference between the amount the contract is in the money and the strike price. The seller of this option must therefore pay a debit in cash to complete the transaction.

Physical Delivery occurs on American-style options, like those of SPY. This type of delivery requires the actual underlying asset to be delivered upon the specified delivery date. Because SPY is a stock, shares of SPY stock will be transferred at expiration for all in-the-money put and call contracts. How much? 100 shares per contract.

This type of delivery poses a significant risk, and it is just another reason why professional traders choose SPX over SPY. What happens if you’re short a GOOGLE (GOOGL) call that suddenly becomes in-the-money during the last seconds of trading? You’ll have to deliver 100 short shares of GOOGL. Unless you have $240,000 laying around, you may be in trouble.

If you still aren’t worried about assignment risk, just watch the clip below from tastyworks (17:00) and learn how a single retail investor almost wiped out thinkorswim in its early days. But just know: options contracts are rarely assigned.

A Lesson on the Dangers of Assignment

For settlement type, SPX appears to be the clear winner in the eyes of most traders.

Tax Advantages of SPX over SPY

For most investors, trading index options (SPX) over ETFs (SPY) makes sense when it comes to taxation. Why?

In 2021 (and beyond presumably), the IRS gives index options preferential treatment. Listed under section 1256 of the tax code, the gains and losses on certain exchange-traded options (like SPX) are entitled to a tax rate equal to 60% long-term and 40% short-term capital gain or loss.

The profits and losses on ETF options (like SPY) are typically treated completely as short-term capital gains. Here’s what the Chicago Board Options Exchange (CBOE) says about these taxes:

The added tax-benefit of index options will of course depend on an investor’s tax profile, but, generally speaking, index options are more monetarily beneficial when it comes to tax time than equity and ETF options. Another win for SPX!

SPY vs SPY: Notional Value and Flexibility

The notional value of SPX is 10 times greater than that of SPY. Because of this lofty price, trading certain strategies on SPX vs SPY can cost a lot of money. Take a look below at the cost of buying an at-the-money call option on SPX (left) vs buying an at-the-money call on SPY (right) on the tastyworks platform.

SPX Option Prices

SPY Option Prices

Luckily for us, most successful traders don’t simply buy or sell single options; they create spreads. When you’re trading spreads (verticals, iron condors, calendars, etc) we don’t care what the value of the underlying is. Selling a ten-point spread for $1 is going to cost us $9, no matter what the price of the underlying is.

A potential downside for SPX involves the width of its strike prices. SPX strike prices generally are separated by a width of $5 (you can see this in the above image), making it impossible to do a one-point spread.

Spy, on the other hand, typically lists its strike prices $1 apart. Sometimes, SPY even lists its strike prices in half-point intervals. This means that in theory, you could do a half-point spread! For small traders, the generous strike structure of SPY has added benefits.

Liquidity

SPY is the most liquid equity-based trading product in the world. This means options volume is high and the bid ask spread is tight. Stock on SPY trades over 80 million shares per day. So far today, at midday, the volume of options trading on SPY is about 600k million contracts. This liquidity almost guarantees great fills.

SPX, on the other hand, isn’t as liquid. That isn’t to say the product is not liquid – it just isn’t as liquid as SPY. Options contracts on SPX have traded at a volume of 245k contracts so far today. If that doesn’t seem like a lot, compare that number to Johnson & Johnson (JNJ), which has traded only 2,500 option contracts all day.

Generally speaking, liquidity in SPX is not a problem.

Conclusion

Every trader has their own style. Most savvy traders, however, from the numerous reasons listed above, prefer to trade SPX when given a choice.

Remember, trading options is very risky. To learn more about these risks, please read the Characteristics and Risks of Standardized Options from The OCC.

Happy trading!

SPX vs SPY: FAQs

Is it better to trade SPY or SPX options?

For tax reasons, SPX offers many benefits over SPY. Additionally, SPX is cash-settled, so there is no assignment risk. Most professional traders prefer to trade SPX for these reasons. SPY, however, offers tighter strike prices and more liquid markets.

Is SPX the same as SPY?

Though SPX and SPY both track an mirror the S&P 500 stock market index, they are two different products. SPX is an index and SPY is an ETF. SPX does not offer shares while SPY does.

Next Lessons

Additional Resources

S&P 500 Index Options – Cboe Global Markets

Trading Index Options: SPX vs. SPY – The Balance

Shorting Put Options for Income Explained

Posted on November 9, 2021February 11, 2022 by Mike Martin

Last updated on February 11th, 2022 , 11:35 am

The above graph represents the profit/loss of a short put option at expiration, where X represents the strike price of the put sold.

Short Put Option Definition

Selling (writing) put options is a neutral to bullish options trading strategy with potentially great risk. Since short-put sellers are the counterparty to long-put buyers, traders utilizing this strategy incur the obligation to purchase the underlying security at the strike price specified should the long party exercise their long put option.

Short Put Option Inputs

● Short Put Option at Strike Price X

Short Put Option Profile

Maximum Profit: Put Sale Price (Credit Received) x 100

Maximum Loss: (Put Strike Price – Credit Received) x 100

Breakeven Price: Put Strike – Credit received

Probability of Profit: Between 50-99% Depending on Strike of Put Sold

Assignment Risk: Increases with Falling Extrinsic Value

In an environment where interest rates are hovering near 0%, investors are seeking alternative ways to generate income.

Many investors are turning to selling put options for income. This market-neutral/bullish options strategy is more popular than ever amongst income-thirsty investors.

Why? The majority of the time, selling put options is a great way to generate steady income. However, this relative stability of income comes not without great risks.

Highlights

When you sell a put option “naked”, the most you will ever make is the premium received; maximum loss can be enormous, occurring only rarely when the underlying falls to $0 in value
Options premiums increase with time and implied volatility
A short put option that is out-of-the-money at expiration will expire worthless and the full premium will be collected
Traders have three choices when their put option is near or at-the-money as expiration nears; close the put in the market, be assigned and purchase the stock, or “roll” the trade via a calendar or diagonal spread

In order to understand the short put options trading strategy, we must first understand the mechanics of long puts.

Long Put Option Explained

Traders who buy put options are typically extremely bearish on an underlying stock/security. Let’s take a look at the textbook definition of a long put, then jump right into an example.

Long Put Option Definition: A long put option is a derivative that gives the owner the right, but not the obligation, to sell a certain amount of a security (stock) at a specified price (strike price) by a specific date (expiration date).

Long Put Option Example

Let’s assume we are extremely bearish on AAPL with the stock trading at $151. We are quite confident the price will fall dramatically in the time leading up to, and following, the company reporting earnings in the weeks ahead.

After scanning the options chain for puts, we decide to purchase a 145 s put on AAPL expiring in 39 days. Below, you will find the details of our trade.

AAPL Long Put Contract

Initial AAPL Stock Price: $151

Put Strike Price: 145

Expiration: 37 Days Away

Put Purchase Price: $2

Put Breakeven Stock Price: 145 Strike – $2 Debit = $143

Maximum Profit Potential: $143 ($14,300)

Maximum Potential Loss: $2 ($200)

In the above example, we purchased an out-of-the-money put at the strike price of 145 for a debit of $2. Whenever you purchase an option (or anything!) the most you will ever lose is the purchase price paid. Therefore, when we buy this option, we can only ever lose $2 (or $200 taking into account the multiplier effect of 100).

Under what circumstance do we lose the entire premium paid? If the stock price closes above our strike price at expiration. Put options give the holder the right (but not obligation) to sell stock at the strike price. Why on earth would anyone want to sell stock at the strike price if the market stock price is more favorable? They wouldn’t.

How much can we make on this trade? Our best-case scenario will happen if AAPL is trading at zero by expiration (unlikely!). We paid $2 for a put option at the 145 strike price. To determine our maximum profit, just subtract the debit paid from the strike price (145-2) and that will give us a maximum potential profit of $143 ($14,300). This will occur with AAPL trading at zero on expiration in 39 days; again, unlikely.

Short Put Option Introduction

Options are incredibly versatile investment vehicles. You can combine calls and puts in innumerable ways. In addition to buying options, you can also sell options.

Many professional traders exclusively sell options. Selling options naked, however, introduces traders to potentially devastating risks. Let’s return to our above AAPL trade, but this time let’s sell the put option instead of buying it. Here are our trade details:

AAPL Short Put Contract

Initial AAPL Stock Price: $151

Put Strike Price: 145

Expiration: 37 Days Away

Put Sale Price: $2

Put Breakeven Stock Price: 145 Strike – $2 Premium= $143

Maximum Profit Potential: $2 ($200)

Maximum Potential Loss: $143 ($14,300)

We are going to focus on two components in the above table: maximum profit and maximum loss.

Maximum Profit in Short Puts

In our previous long put example, our maximum profit was $143 ($14,300). In the short put example above, our profit is only $2 ($200). Why is this? When you sell an option, the most you can ever make is the premium received.

Long put options are profitable only in bearish markets. Short put options, however, are profitable in neutral, bullish and even minorly bearish markets. In theory, this strategy should be profitable the majority of the time.

When you sell a put option, probability is on your side. Of course, you give something up for your high odds of success. This comes in the form of risk.

Maximum Loss in Short Puts

When you sell a put optoin, your maximum loss occurs when the stock is trading at zero on expiration. For our trade, we would incur a loss of $143 ($14,300) if AAPL were to fall to zero by expiration. That’s a lot of money!

We are risking over 14k to make a lousy $200. Is that a trade you’d like to make?

Probably not. So why do so many investors sell put options for income?

Because chances are, the stock price will not be zero when our option expires. Chances are, AAPL will be trading above $145, resulting in a maximum profit to us.

So what, exactly, are the odds our trade has of achieving maximum profit? The Greek “delta” tells us. Let’s take a look at how delta interacts with different strike prices next.

Short Put Options: Choosing a Strike Price

Traders who sell put options for income generally sell strike prices that are considerably out-of-the-money. Why? The further out-of-the-money a put option is, the greater the odds that option will have of expiring worthless.

But can we determine what these odds are by a method other than guessing? Yes!

Take a look at the below put options chain for Invesco QQQ Trust (QQQ) on the tastyworks trading platform.

QQQ Put Options and Delta

We are interested in the column titled “Delta” in green. Delta is one of the option Greeks. This Greek can be useful in many ways, including telling us the odds that an option has of expiring in the money.

Delta and In-The-Money Odds

QQQ is currently trading at $399/share. The put options in the above table expire in 9 days.

Take a look at the 399 put. Its delta is -0.50. This tells us the 399 at-the-money option has a 50% chance of expiring in-the-money. This should make sense; since the stock is trading at this same price, there should be a 50/50 chance that AAPL will either be above or below this level at expiration.

Let’s look at the 390 put now. In order for this option to be in-the-money, the stock needs to fall by $9 by expiration, which is 9 days away.

What are the odds this happens?

Just look at the delta, which is -0.23 for the 390 put. This option, therefore, has a 23% chance of expiring in-the-money on expiration. In other words, if you sell this put option, you have a 77% chance (100-23 delta) of the option expiring worthless and achieving maximum profit.

77% chance of success sounds pretty good. However, take note of how the premium dwindles the further out-of-the-money you go. If you recall the massive maximum loss potential on short puts, this low premium does not make for a very nice risk/reward profile.

Short Put Options and Time Value

The time-to-expiration will affect how much premium you can collect from selling a put option. The greater the time to expiration, the greater premium you will receive. Take a look at the below two options chains on the QQQ’s from the tastyworks trading platform.

QQQ Put Options and Days to Expiration

The options in the green square on top expire in 2 days; the options in the lower green square expire in 11 days.

Compare the pricing on the 396 puts expiring in 2 days to the 396 puts expiring in 11 days. The options with 2 days left are trading at $1,14, while the options with 11 days left are trading at $3.80.

Additionally, you can see the delta (or the odds of expiring in-the-money) increases for options with more days to expiration.

Why is this? The underlying has more time to approach the strike price level. A lot of options trading can be understood without using math at all; instead of understanding rules, just think intuitively about a scenario, and it should make sense.

Short Put Options and Market Volatility

High implied volatility is synonymous with high options premiums.

Broad market volatility can be gauged by looking at the VIX index. The VIX index measures the market’s expectations for volatility over the proceeding 30 days based on near-term S&P 500 index options. The higher the level of the VIX, the higher the premiums for options will be.

Traders looking to sell put options for income could receive a greater premium if they sell during times of elevated volatility. However, this comes with greater risks too – in volatile times, the underlying has a greater chance of plummeting and breaching the strike price of put options sold.

Take a look at the below 5-year chart, which compares SPY (an S&P 500 tracking ETF) to the VIX. When the blue line is at its zenith, options premiums are very elevated. Notice how this coincides with large downturns in the SPX.

Chart from Google Finance

Short Put Options and Stock Volatility

The levels of implied volatility on individual stocks can vary widely.

Two stock trading at the same exact price can yield vastly different option premiums (and risks) for similar strike prices. Check out the below options chains from tastyworks, comparing two stocks currently trading at the same exact price.

LMT Put Options

Bill Put Options

The underlying stock prices for the above two options chains (BILL and LMT) are both trading at $342/share.

Why, then, are the premiums so vastly different?

Comparing Implied Volatility in Options

The 340 put option for BILL is trading around $12, while the 340 put option for LMT is trading at $4, about a third of the price. The underlying stock, however, is trading at the same exact price for both. Additionally, the time to expiration (10 days) is also the same. Why such a huge difference in premium?

We’ll find our answer in the upper right-hand corner of the options chains, where I have circled the “Implied Volatility” (IV) in green.

IV measures the expected volatility of an underlying security over the life of an option. For the November 19 options above, the IV for BILL is 64.6% while the IV for LMT is only 7.59%.

The greater the IV, the higher the premiums (and risks!) options will have. History tells us that the stock of BILL undulates more wildly than that of LMT, therefore the pricing of BILL’s options must be elevated to reflect the stock’s future potential moves.

Selling Put Options and The Greeks

We touched upon the Greek “delta” earlier. However, if you want to be a pro options trader, having all of the Greeks in your toolbox is a must. Below, we have provided a cheat sheet that shows the relationship between short put options and the Greeks.

Short Puts & The Greeks

If you’d like to learn more about the Greeks, read our article, “Option Greeks Explained: Delta, Gamma, Theta & Vega.”

Historical Performance of Selling Put Options

The best resource we have for the long-run profitability of selling put options comes from The Cboe S&P 500 PutWrite Index, PUT.

The PUT index tracks the performance of at-the-money puts, not out-of-the-money puts, which are the favorite amongst traders looking to generate income.

Short at-the-money puts have greater premiums than out-of-the-money puts. They also have a lower chance of expiring worthless.

With that being said, the index does give us a ballpark idea of the long-term performance of selling put options against an index (SPX).

The below chart compares the historical dollar comparison performance of PUT (green) to SPX (black).

Source: CBOE Website

Since its inception in 2007, the PUT index has vastly underperformed the SPX index.

Closing Short Put Options

If all goes as planned, your short put option will expire worthless, and you’ll collect the full premium from the trade.

But sometimes, the market moves against us. If you are short a put option and the underlying is close to or has already breached your strike price at or near expiration, you have one of three options:

1.) Let the option be assigned and purchase the stock.

Some traders that sell put options for income do so with the intent to purchase the stock should it breach the level of the put sold. Purchasing stock, however, can be quite costly, so it is advised that traders have the capital required to hold the underlying shares in these scenarios, or else your broker will liquidate the position.

2.) Close the put in the open market.

If you want to throw in the towel on your trade, the best option is to simply buy back your short put in the market.

3.) Roll your put option.

If you want to remain in the position, you can always “roll” your short put from one expiration cycle to another. This can be accomplished in a single trade. Your options are a “calendar spread” or a “diagonal spread”.

Calendar Spread: In a calendar spread, you will simply roll the same strike price from one expiration to another
Diagonal Spread: Sometimes, traders want to sell a put option that is further out-of-the-money when their short is breached. A diagonal spread can accomplish this. This strategy consists of buying and selling options of the same type, but opposing strikes and expirations.

Final Word

Selling put options naked is a risky business. The odds are in your favor for this income generation strategy, but when the market moves against you, watch out.

In my days as an options broker, I have seen years of profits from selling puts wiped out in a single day. It is because of this many traders refer to selling options naked as “picking up pennies in front of a steam roller”.

Be careful out there, traders!

Next Lesson

Additional Resources

How to Sell Put Options to Benefit in Any Market – Investopedia

Selling Put Options: Tutorial + Examples – Lyn Alden

Short Put Option Strategy: tastyworks

Payment for Order Flow Explained Simply (w/ Visuals)

Posted on November 5, 2021April 27, 2022 by Mike Martin

Last updated on April 27th, 2022 , 04:59 am

For sixteen years, Gary Gensler, (the Chairman of the SEC) had his heart set on improving the profits at Goldman Sachs. Today, it is set on the advocation of retail traders. He wants to do away with payment for order flow.

Payment for order flow (PFOF). Doesn’t it sound sinister? Like some kind of Faustian deal? The father of it may even be thought of like a modern-day Mephistopheles: none other than Bernie Madoff invented the system, whereby brokers receive compensation for routing their orders to market makers.

So how, exactly, does this system work?

Highlights

In payment for order flow (PFOF), market makers pay brokers for filling customer orders
In these flash-auctions, the best bid/offer wins; payment is sent from the market maker to the broker for filling the order, and the customer is filled
Outwardly, wholesale market makers welcome an end to PFOF as this means they’ll simply fill the same orders without having to pay
More transparency is needed in the system to assure investors they are indeed receiving the best fills possible

Payment for Order Flow Example

Let’s say your friend Fred wants to sell his apple. He hires you (the broker) to sell this apple for him. You then take the apple to market.

For a long time, there were only a few vendors in town. We will say three (market makers on public exchanges like the CBOE, NYSE, NASDAQ).

Now if you are selling an apple for a client, wouldn’t it be better if there was more competition? We want them to fight for the right to purchase our apple, thus making the spread tighter.

A few outsiders (wholesale market makers like Citadel and Virtu) got wind of the wide spreads in the apple market. One day, they are standing next to the major vendors, giving you their own markets.

Our apple auction begins. The newbies are aggressive and offer you the best fill, better than the old players. In fact, two of these best markets presented to you by the newcomers offer you the same price.

So who do you sell the apple to?

One vendor (market maker) says they’ll personally pay you a penny if you send him the order. This is money you can put in your pocket. This is NOT money for Fred.

You sell the apple to this party and then walk home, rolling that penny over in your pocket the entire time.

“Here’s your money.” you say to Fred, “Also, I got paid a penny, but I sold the apple at the best possible price.”

“Cool.” replies Fred.

“I am going to invest this penny in new pair of sneakers so I can get to the market faster.”

“I don’t care.” replies Fred.

Payment for Order Flow: A Benefit to Retail Traders?

Of course, in this situation, our apple is stock or options (most likely to be options) and the apple vendors are market makers. You are the broker here.

So what about that money you collected from the market maker? Instead of sneakers, you will use the funds to invest in technology and pay for the cost of your operations. After all, if you run an apple to the market for someone, shouldn’t you get paid? Capitalism isn’t charity.

In a nutshell, this is how PFOF works.

Markets Without Payment for Order Flow

So let’s say Gensler gets his way and PFOF is banned. What then?

For one, commissions may come back. There is a chance this may happen, but it’s unlikely. Too many large brokers can exist just fine without commissions.

Realistically, brokers may decide to “internalize” their order flow. These orders will never see competition. Technically, they must provide the best execution. However, the fills from internalization may be more nebulous than with PFOF!

In-house exchanges may be established, and investors may have to pay a fee to trade on these exchanges. Again, the markets here will not be as liquid nor as good as they are at present.

No matter how it plays out, investors will pay for a ban on PFOF, either through fees, commissions or in wider spreads and poorer liquidity.

PFOF Ban: Win-Win for Hedge Funds?

So what happens to the “villain” in this tale?

During an interview at The Economic Club of Chicago, the CEO of Citadel, Ken Griffin, said, “Payment for order flow is a cost to me.”

Mr. Griffin seems happy for a ban; after all, this will only mean Citadel can fill the same orders without paying!

But does Mr. Griffin truly want to do away with PFOF? What will actually happen at Citadel? We can’t say for certain. Perhaps his rhetoric is all strategy. All we do know is that a PFOF ban will most likely hurt the retail investor.

PFOF: What's the Solution ?

What’s the answer?

PFOF is built mostly on a system of trust. It assumes we trust our broker. Even though by law brokers most get us the best fill, we have no transparent way of knowing for certain whether or not they do.

Most Americans have an inherent distrust of Wall Street. This is in our blood. We will never take a Wall Street executive at their word. The only solution, that I can see, is to find a method of promulgation that removes the veil of ambiguity around PFOF.

Can they prove, clearly and on a regular basis, that they are indeed getting us the best fills?

But net-net, at the end of the day, empirical research has proved the system ain’t broken. Why fix it?

Next Lesson

Additional Resources

Payment for Order Flow (PFOF) – Investopedia

Payment for order flow – Wikipedia

Call and Put Options at Expiration

Posted on November 4, 2021March 2, 2022 by Mike Martin

Last updated on March 2nd, 2022 , 08:14 am

Where do options go when they expire? If an option has no value, do you need to take any action? What will happen if you do not sell an in-the-money option by expiration?

Projectfinance has answers to all of your questions. In this article, we will explore the various outcomes of holding call and put options through expiration.

Highlights

Out-of-the-money options “expire worthless” at expiration; no action is required
At-the-money options pose significant risks to traders in the time leading up to expiration. Best practice is to buy back short options before expiration to avoid the unnecessary stock risk
In-the-money options will be assigned/exercised at expiration
In-the-money long calls/puts will settle to long/short stock position. In-the-money short calls/puts will settle to short/long stock positions.

Holding certain options through expiration can introduce traders to unnecessary risks. Out-of-the-money options, however, pose no risk. Let’s start off with these types of options first!

Out-Of-The-Money Options at Expiration

If you are either long or short an options contract that is out-of-the money at expiration, you will generally have nothing to worry about. No action is required. Zip. Nada. Zilch.

Why? It makes zero financial sense for the owner of a long call or long put to exercise their right to buy/sell a stock (or ETF, or any security) if the current market price of that stock is more favorable than the strike price of your option.

Out-Of-The-Money Option at Expiration Example

For example, let’s say you own a 160 strike price call on AAPL. In the minutes leading up to expiration, AAPL is trading at $150 a share.

If you were to exercise your call contract, you would purchase 100 shares of AAPL at $160/share. Why on earth would you do this? You wouldn’t’. The best decision you can make is to do nothing.

Consequently, this means that if you are short an out-of-the-money option going into expiration, no action is required.

No long party in their right mind would exercise their call at this strike price. Therefore, your short position has no assignment risk.

But what if someone does exercise their option at this strike price? Rarely, this occurs.

Long option holders (of American-style options) have the right to exercise their option at any time. So let’s say they do this with an out-of-the-money option. This is a good thing for you! You’ll either buy (for short puts assigned) or sell (for short calls assigned) the underlying stock at a better price! Make sure to send them a thank-you note.

But 99.99% of the time, these options will “expire worthless”. The long party will lose the full premium; the short party will make the full premium.

Out-Of-The-Money Calls vs Puts at Expiration

In order to determine whether or not your option is “out-of-the-money”, understanding moneyness helps. A cheat is provided below. However, if you’d like to study up on moneyness, read our article, “Option Moneyness Explained.”

Call options expire worthless when the strike price is higher than the price of the stock/security at expiration

Put options expire worthless whe the strike price is lower than the price of the stock/security at expiration

Worthless Options Post Expiration

So what exactly happens to your out-of-the-money options at expiration? We said they “expire worthless”, but where do they go?

They simply cease to exist. They are no more. The contract has expired. They are yesterday’s news.

Ok. So out-of-the-money options are easy.

But what if, at the moments leading up to expiration, the stock price is hovering right around your strike price?

At-The-Money Options at Expiration

With at-the-money options, things aren’t so cut and dry. To better understand what could happen to these options at expiration, let’s return to our AAPL trade.

At-The-Money Option at Expiration Example

We are long the 150 AAPL call. In the minutes leading up to expiration, AAPL is trading at $149.89.

Our option is technically “out-of-the-money”, but what happens if AAPL shoots up by a quarter in the last second of trading?

If you’re long this option, your broker will automatically exercise your call if it is in-the-money post expiration (the same thing would happen for puts). However, you can contact your broker and request your long not be exercised. You need a lot more money to hold 100 shares of AAPL stock (15k right now) than your call option.

Now, what about if instead of being long, you were short this AAPL call option? Well, you’d be in a tight spot. There is no guarantee that an option only slightly in-the-money will be exercised, so offsetting the soon-to-be stock with stock now isn’t a sure hedge.

At-The-Money Options and Pin Rsk

What do you do? Nothing. This is called “Pin Risk” (Investopedia) and it’s very real.

Pin Risk Definition: In options trading, pin risk occurs when the strike price of an option is trading in a close range with the underlying stock/security price as expiration approaches.

I’ve been here before. It sucks. If you have a large position, it could wipe you out.

It’s always best practice to buy back short positions that have even the remotest chance of being assigned before expiration. It’ll cost you pennies, and could save you thousands.

On Wall Street, bears make money, bulls make money, but pigs get slaughtered!

So what happens if your long does indeed get exercised or your short gets assigned?

In-The-Money Options at Expiration

If your option is in-the-money at expiration, you may be in trouble.

Again, in order to understand whether or not your options position is in danger of being assigned, understanding moneyness is imperative. It’s simple stuff, truly. American-options that are in-the-money at expiration will be exercised/assigned.

So what does this mean? It depends on the type of option.

In-The-Money Call Options at Expiration

Long call options that are in-the-money at expiration will be exercised, and (usually) 100 long shares of the stock/security per option contract will appear in your account, usually within one day.

Short call options that are in-the-money at expiration will be assigned, and (usually) 100 short shares of the stock/security per option contract will appear in your account, usually within one day

In-The Money Put Options at Expiration

Long put options that are in-the-money at expiration will be exercised, and (usually) 100 short shares of the stock/security per option contract will appear in your account, usually within one day.

Short put options that are in-the-money at expiration will be assigned, and (usually) 100 long shares of the stock/security per option contract will appear in your account, usually within one day.

Note! I mentioned that "usually" 100 shares of stock appear in your account. This is because of the "multiplier effect". One option contract usually represents 100 shares of stock but not always!

American vs European Style Options

Most options on stock and ETF products are American-style. This means they are settled in stock. AAPL options, like most equities, are settled American-style.

But not all options are American Style. Some options are “European Style”. In addition to not allowing for early exercise/assignment, European options are settled in cash.

Index Options (like SPX, NDX and RUT) are European Style, and thus cash-settled.

Cash-Settled Definition: In cash-settled products, there is no physical delivery (stock) after expiration for in-the-money options. Instead, a transfer of cash occurs.

Check out the below table for a comparison of these two types of options. For a more in-depth review (like understanding the taxation difference), check out our article comparing SPX to SPY options (European style vs American style).

	European Style	American Style
Settlement	Cash-Settled	Physical Delivery
Tax Advantages	Has Tax Advantages	No Tax Advantages
Dividend	No Dividend	Issues Dividend

European Style Options Explained

European style options (Investopedia) don’t have the huge stock risk that comes with American style options. If you’re trading SPX and your short call option is in the money by $1 at expiration, you’ll simply be required to transfer that cash difference to the long party at expiration.

Professional traders love trading index options for this reason. In addition to there being no dividend risk, European options shield short options traders from early assignment risk. Additionally, pin risk does not involve that huge monetary transfer of stock. A simple and relatively small transfer of cash settles these options. It doesn’t matter where SPX opens the next day, your position settles off the closing price at expiration.

Final Word

In order to understand the repercussions of expiration on your options, you must understand moneyness. In-the-money American-style options introduce investors to potentially huge monetary risks.

For a deeper understanding of options trading, please check out our articles below!

Next Lesson

Additional Resources

Options Expiration Calendar 2022 – MarketWatch

What Happens When Options Expire | tastytrade

Option Moneyness: In The Money, At The Money and Out Of The Money

Posted on November 3, 2021March 17, 2022 by Mike Martin

Last updated on March 17th, 2022 , 05:46 pm

All call and put options contracts exist in one one three “moneyness” states: in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM).

To truly understand moneyness, we must first understand the difference between intrinsic value and extrinsic value.

Highlights

Option “Moneyness” refers to the relationship between an option’s strike price and the current stock price.
In-the-money options have intrinsic value. For calls, the strike price of these options resides below the current stock price. For puts, in-the-money options reside above the current stock price.
At-the-money options refer to strike prices that are trading at (or very close to) the current stock price.
Out-of-the-money options have zero intrinsic value. Calls are out-of-the-money if the strike price is above the current stock price. Put are out-of-the-money when the strike price is below the current stock price.

Intrinsic Value Explained

The price of an options contract consists entirely of intrinsic and/or extrinsic value.

Intrinsic value is simply how much value an option has on its own. In other words, this is the value an option would have if it were exercised at any given moment in time. Intrinsic value discounts time and implied volatility.

For call options, intrinsic value exists when the strike price of the option is trading below the current stock/security price. The amount of intrinsic value in a call option is calculated by subtracting the strike price from the current stock/security price.

For put options, intrinsic value exists when the strike price of the option is trading above the current stock/security price. The amount of intrinsic value in a put option is calculated by subtracting the underlying stock price from the options strike price.

If the strike price of a call option is trading above the current stock price, no intrinsic value exists. Likewise, if the strike price of a put option is trading below the current stock/security price, no intrinsic value exists.

Extrinsic Value Explained

In options trading, extrinsic value represents the portion of an options price that is not intrinsic value. It is everything that is “left over”. Both implied volatility and time affect the extrinsic value of an option.

If the strike price of a call option is above the stock price, it will have no intrinsic value. Since the value of an option must be entirely intrinsic and/or extrinsic value, we can deduce the price of these options must consist entirely of extrinsic value.

If the strike price of a put option is below the current stock price, this option will have no intrinsic value. Therefore (like call options), its entire premium must consist entirely of extrinsic value.

Determining how much intrinsic and/or extrinsic value exists in an option depends on where the stock is trading. These proportions can be in constant flux with the market, as illustrated in the 105 strike price call option graph below.

Extrinsic and Intrinsic Value Changing

Before we move on, let’s break down intrinsic and extrinsic value in an Apple call example.

AAPL Call Option Example

Stock Price: $150

Call Strike Price: 149

Call Option Price: $3

Extrinsic Value: $2

Intrinsic Value: $1

So now that you understand how these values work, understanding moneyness will be a cinch!

In-The-Money (ITM) Options Explained

If the strike price of a call option is below the stock price, the call option will be in-the-money. The depth of an options moneyness will determine its intrinsic value.

Call Options Chain: In-The-Money?

If the strike price of a put option is above the current stock price, that put option will be in-the-money. Like that of call options, the amount a put option is in-the-money by will determine its intrinsic value.

Put Options Chain: In-The-Money?

At-The-Money (ATM) Options Explained

At-the-money options have a strike price that is trading at or very near the current stock price. Though technically just about all options will be in or out-of-the-money, this term is used as a generalization. If an option is a few cents in the money, though technically “in-the-money”, most traders will refer to the option as at-the-money.

Put & Call Options Chain: At-The-Money?

Out-Of-The-Money (OTM) Options Explained

Out-of-the-money options are composed completely of extrinsic value; they have zero intrinsic value.

A call option is “out-of-the-money” when the strike price is above the current stock price.

Call Options Chain: Out-Of-The-Money?

A put option is “out-of-the-money” when the strike price is below the current stock price.

Put Options Chain: Out-Of-The-Money?

Final Word

Understanding an options moneyness is simple. After determining the type of option (call or put), simply locate where the strike price of that option is in relation to the stock price. That’s it!

Not considering volatility and time, if an option has value on its own, it will be in-the-money. If an option has none of this “intrinsic” value, it will be out-of-the-money.

Next Lesson

Additional Resources

What Is Option Moneyness? – Investopedia

Calculating Options Moneyness & Intrinsic Value – CME Group

Option Greeks Explained: Delta, Gamma, Theta & Vega

Posted on November 1, 2021February 11, 2022 by Mike Martin

Last updated on February 11th, 2022 , 12:14 pm

Highlights

The “Greeks” help traders predict how options will respond to various market changes in the underlying
Delta and gamma predict option price movement in response to changes in the underlying price
Theta tells traders how much extrinsic value an option will shed after one day, with all other conditions remaining constant
Vega predicts how an options price will respond to changes in implied volatility
Most trading platforms can be laid out to include the Greeks

There are few things more daunting to the amateur options trader than the series of complex mathematical equations dubbed the Greeks. Just trying to wrap your head around these risk-management equations is panic-inducing. However, if you want to become a serious options trader, you must understand them.

The good news? You do not need an advanced degree from MIT to equate and understand these helpful market measures. On almost all trading platforms, the computations are done for us. All we need to do is interpret their meanings, which we will accomplish in this article.

Today we will focus on the big four Greeks: delta, gamma, theta, and vega.

Delta and gamma work together, measuring how options respond to changes in the underlying price. Theta tells us how much an option changes in response to the passage of time. Lastly, vega tells us how sensitive an option is to changes in the implied volatility of the underlying.

Possessing a basic understanding of these absolutely vital risk-management tools will surely pay your portfolio dividends in the future. Let’s get started!

The Option Greeks and Time

Perhaps the most important thing to know about the Greeks is that they are forward-looking. Think of them as little-time travelers, peering into the future and reporting back to you what could happen under various circumstances.

The most effective education happens when the student wants to learn. Therefore, before we continue, let’s plant that seed.

If you’ve ever been long a call option, haven’t you wondered why that option reacts the way it does to changes in stock price?

I have talked to many long-call holders on the phone who were a little more than discouraged to discover their option didn’t rise in value as much as they thought it would when the underlying stock rallied.

If only there was a way to tell ahead of time what would happen to an options price if the stock shot up by a dollar…oh, but there is!

1. Option Delta Explained

Enter delta. The delta of an option tells us how an option will react to a change in stock price before that price change happens. Pretty cool, right?

Δ Option Delta Definition: In mathematics, an uppercase delta represents the change in a quantity. In options trading, the delta of a position is expressed as a ratio of change. This ratio tells us how much an options position is expected to change in value with a corresponding $1 move in the underlying security.

Option Delta in Calls and Puts

The value of an options delta will depend on the type of option:

All call options will have a delta value between 0 and +1.
All put options will have a delta value between 0 and -1.

Why is the delta negative for put options? Put options have an inverse relationship with a stock price; when the stock goes up, the value of the put goes down.

The delta of an option simply tells us how the price of an option will change if the underlying stock price were to immediately rise or fall by a dollar.

If you were long a call, and that call had a delta of 0.34, that option would increase in value by 34 cents if the underlying stock were to go up a dollar. Conversely, the option would fall by 34 cents if the underlying stock fell by a dollar.

Pretty simple stuff, right? Things can get a bit more complicated when you get into delta hedging, but we’ll save that for another lesson.

Let’s look at an example now on a truncated options chain.

AAPL Option Delta Example

Type	Strike	Price	Delta	+$1 Share Price Affect	-$1 Share Price Affect
Call	147	3.25	.64	3.89	2.61
Call	148	2.63	.52	3.15	2.11
Call	149	2.11	.42	2.60	1.62

Where AAPL is trading at $148.20

The above options chain shows us how an increase/decrease in the price of Apple (AAPL) by $1 affects various option prices after contributing for delta.

If you want to determine how much an option will increase or decrease in response to a $1 move in the underlying, just add/subtract the delta from the option’s current price. Voila. That’s it.

Delta and Moneyness

In the above table, AAPL stock is trading at $148.20. That means that the 147 call is in-the-money, the 148 call is (pretty close to) at-the-money and the 149 call is out-of-the-money.

We can see the 147 call has the highest delta. The delta of in-the-money call options approaches a positive 1 as expiration nears.

The 149 call has the lowest delta. The delta of out-of-the-money calls approaches zero as expirations near.

At-the-money-options (the 148 call) tend to have a delta of around 0.50 over their life. Ultimately, just about all options will close in or out-of-the-money.

The further we go out-of-the-money, the less effect stock price movement has on our options delta. If you’re long options, decreasing delta is bad news. However, if you’re short options, low deltas are a good thing.

Before we move on, take a moment to study the below graph, which shows the relationship between option delta and strike price (the dashed vertical line represents the current stock price, which is also where at-the-money options reside).

Delta vs Strike Price

Delta and Moneyness Odds

Delta has another function; it also tells us the odds an option has of expiring in-the-money.

Take a look at the 149 call in our AAPL option chain above. The delta for this option is 0.42. In addition to telling us this option will increase in value by 0.42 if the stock were to go up by a dollar, it also represents the odds that an option has of expiring in-the-money.

The 149 call has a 42% chance of being in-the-money at expiration. The 148 call has a 52% chance of expiring in-the-money.

Bear in mind these numbers are in constant flux with the underlying.

How Delta Mimics Shares of Stock

We’re not quite done with delta yet. I hope you’re beginning to see why it is the first Greek on this list! It is the most important by far.

The delta of a position can also tell us “how many” shares of stock an option trades like. If our delta is 0.20, our option will mimic the profit/loss on approximately 20 shares of stock. If an option has a delta of 1 (as many deep-in-the-money options have) that option will trade like 100 shares of stock.

Option Delta Summary

Before we move on to our next Greek, let’s sum up all we’ve learned about delta.

The delta of an options position tells us how much the value of that particular option will fluctuate with a corresponding $1 move in the stock price.
The delta of an option represents the odds that a particular option has of expiring in the money. A delta of 0.30 has a thirty percent chance of expiring in-the-money.
Delta also tells us how many shares of stock our option “trades like”. In a profit/loss profile, a delta of +0.50 will trade similar to 50 shares of the underlying security.

To learn more about delta, please check out our video below!

2. Option Gamma Explained

Gamma takes a look at delta and then goes a step further. You can’t understand gamma without first understanding delta, so make sure you have a solid grasp of the concepts in our first Greek before moving on.

(Γ) Option Gamma Definition: In options trading, the Greek “gamma” measures the rate at which an options delta changes in correspondence to the price of the underlying security.

We learned earlier that the delta of an option is in constant flux with the market. If you watch the Greeks on your trading software, you’ll see they change just as frequently as the stock changes. Where do we find our footing?

Gamma steps in here and tells us how the future delta of an option will change in response to a one-point move in the underlying stock.

Sound confusing? We’ll clear the air in a moment with an example. First, let’s understand a few key concepts about gamma.

1.) Long Options Yield Positive Gamma; Short Options Yield Negative Gamma

We learned before that the delta of most put options has a negative value, whereas the delta of most call options has a positive value.

This changes for gamma. Regardless of the option type (call or put), long options always yield a positive gamma. Short options, however, will always yield a negative gamma.

2.) At-the-Money-Options Yield the Highest Gamma

The further in-the-money an option is, the higher its delta is. This is not true for gamma. Gamma yields are highest for at-the-money options.

Why is this? The deltas of at-the-money options are most sensitive to stock price changes. The below screenshot (taken from the tastyworks software) illustrates how high gamma gravitates towards at-the-money options.

AAPL Option Gamma Example

Type	Strike	Price	Delta	Gamma	New Delta (+$1 Share Price )	New Delta (-$1 Share Price)
Call	147	3.25	.64	.06	.70	.58
Call	148	2.63	.52	.08	.60	.44
Call	149	2.11	.42	.06	.48	.36

Where AAPL is trading at $148.20

The furthest right two columns in the above table illustrate how an options delta will react to a +/−$1 change in the underlying stock. This is calculated by either adding or subtracting gamma to/from the previous delta.

For a stock increase, we simply add the gamma to the old delta to determine the new delta. For a stock decrease, we subtract the gamma from the delta.

You will notice that the gamma for the 148 call (the at-the-money call) is higher than the other gammas.

As we said earlier, deltas are most sensitive when at-the-money. Since gamma is a derivative of delta, these moneyness structures are most reactionary to stock price changes.

If delta is thought of as the speed at which an option moves, gamma can be thought of as the acceleration of this speed.

Option Gamma vs Days to Expiration

So far, we have looked at how gamma affects the options of a single, near-term expiration cycle. But what affect would time have on the gamma of options expiring in 30 days rather than 3?

Gamma is always greatest for near-term options. The further away an option is from expiration, the less the gamma will be. Take a look at the below graph to get a better understanding of how time affects gamma.

Gamma vs DTE

Option Gamma in Long and Short Options

Short option sellers do not want their position to be in-the-money at expiration. Since gamma is highest for at-the-money options, we can therefore deduce that high gamma is bad news for short option positions.

On the other hand, long option positions profit when the delta approaches 1. Therefore, high gamma is desirable for these positions.

To learn more about gamma, please check out our video below!

3. Option Theta Explained

Our next Greek pertains to something almost all beginner options traders learn the hard way: time decay.

Unlike stock, all options have an expiration date. If an option is out-of-the-money when it expires, its value will be zero.

In an environment where implied volatility and stock price remain constant, an out-of-the-money options contract will perpetually shed its extrinsic value (which is the only value out-of-the-money options have) as expiration nears. The option Greek theta tells us the rate at which this decay will happen.

(Θ) Option Theta Definition: The rate of decline in the value of an option attributed to a one-day change in the time to expiration.

Before we jump into theta, it may be helpful to understand the difference between “intrinsic” and “extrinsic” value in options trading. If you’re already familiar with this, please skip ahead!

Option Theta: Intrinsic and Extrinsic Value

The price of all options consists of intrinsic and/or extrinsic value.

Intrinsic Value Definition: In options trading, intrinsic value represents the value of an option should that option be exercised at the moment of observation.

Extrinsic Value Definition: In options trading, extrinsic value represents all option value that is not intrinsic value.

The intrinsic value of an option is simply the amount that option is in-the-money by. Extrinsic value is everything that is left over. Time and implied volatility play a part in determining an option’s extrinsic value. As time passes, and an option remains out of the money, its extrinsic value will shed. If an option is out-of-the-money on expiration, its value will be zero.

Let’s look at an example.

AAPL Call Option Example

Stock Price: $150
Call Strike Price: 149
Call Option Price: $3
Extrinsic Value: $2
Intrinsic Value $1

Since our above call option is in-the-money by $1, its intrinsic value is $1. The price of the option, however, is $3. Therefore the remaining $2 must be the option’s intrinsic value.

Like the Greeks, intrinsic and extrinsic values are in constant flux with the market. Check out the below graph, which shows how the different values which comprise a NFLX call option change as time passes and the underlying stock price changes.

NFLX Time Decay

Option Theta and Extrinsic Value

Theta is concerned with extrinsic value. This Greek tells us how much “extrinsic value” an option is expected to lose with each passing day. In an environment where the stock price and implied volatility remain constant, time decay causes an option to lose value.

Think about this intuitively. Let’s say a stock is trading at $130/share. You buy the 135 strike price call for 0.40 that expires in thirty days. If 29 days pass and the stock is still trading at $130, won’t your option decline in value? It’ll probably be worth a few pennies if anything. Theta tells us how fast this decay occurs – on a daily basis.

Option Theta in Calls and Puts

Theta is kryptonite for long option positions. If we’re long an option, theta causes it to shed value perpetually. This is particularly detrimental for long out-of-the-money options. Why? These options are comprised completely of extrinsic value. In-the-money-options still have intrinsic value, which is unaffected by the passage of time.

Short option positions, however, love theta. With each passing day, in a constant environment, theta chips away at premium, making a short call or put position more profitable.

For both calls and puts, theta is expressed as a negative value. Like gamma, theta is typically highest for at-the-money options.

AAPL Option Theta Example

Type	Strike	Price	Theta
Call	147	3.25	-.52
Call	148	2.63	-.56
Call	149	2.11	-.54

Where AAPL is trading at $148.20 and expiration 2 days away.

At this point, determining theta should be relatively easy for you. Look at the above options chain, the options of which expire in 2 days.

With these options so near the end of their life, theta is going to be high. If by tomorrow the stock/implied volatility hasn’t changed, the 148 call (at-the-money) will be trading at 2.07 (Option Price 2.63 – Theta .56).

Why such a dramatic change in price? As we said, the option is expiring in 2 days. If we were to look at the theta of an option with a different expiration (30 days to expiration) but the same strike price, the theta will be only -.06.

As the expiration on an option nears, theta accelerates.

Take a moment to study the below image, which shows just how detrimental time can be to the extrinsic value of an at-the-money option over a duration of 90 days.

Time Decay Over 90 days

Option Theta Summary

Before we move on, let’s review a few highlights from theta. After delta, this is the most important Greek.

Theta is typically expressed as a negative value
Theta is highest for at-the-money options
In an environment of constant stock price and implied volatility, theta will perpetually eat away at an options extrinsic value

To learn more about theta, please check out our video below!

4. Option Vega Explained

So far, we have learned about delta, gamma and theta. Delta and gamma show us how an option reacts to a future change in stock price. Theta shows us how an option responds to the passage of time.

But how will an option react to future changes in implied volatility?

This is where vega comes in.

(V) Option Vega Definition: In options trading, Vega measures the expected change in the price of an option in response to a 1% change in implied volatility of the underlying security.

First off, it is important to understand that vega and implied volatility are not synonymous. Volatility measures the instability of a stock; vega shows us how an option reacts to potential, future changes in implied volatility.

Option Vega in Calls and Puts

Let’s first understand the fundamentals of vega.

1.) Vega is Most Affected By At-the-Money Options

I hope you’re starting to see a pattern here. Gamma, theta, and now vega are all at their zenith for at-the-money options. This is true also for vega. Why? At-the-money options are most sensitive to changes in implied volatility.

2.) All Options Have Positive Vega

Whether it be call or put, vega will always be positive for long options. When implied volatility goes up, both calls and puts increase in value. Vega isn’t concerned with the type of option, it focuses on the overall impact a change in future implied volatility will have on all options.

Long options love vega. Why? An increase in implied volatility is synonymous with the increase of an options price. Option sellers, however, do not like an increase in vega as they hope the options price (and the underlying implied volatility) will decrease.

AAPL Option Vega Example

Type	Strike	Price	Vega	+1% Implied Volatility	-2% Implied Volatility
Call	147	3.25	.06	3.31	3.13
Call	148	2.63	.07	2.70	2.49
Call	149	2.11	.06	2.17	1.99

Where AAPL is trading at $148.20 and expiration is 2 days away.

Take a moment to study the above options chain for AAPL. As mentioned above, we can see that the at-the-money option (148 call) has the highest vega.

So how do we determine how the price of an option would change in response to a 1% increase in implied volatility? Simply add the vega to the value of the option. That’s it!

In the far right column, we threw a bit of a curveball; instead of a 1% decrease in volatility, we changed it to a 2% decrease. To determine how an option will react to a 2% decrease (or even 4%) in implied volatility, you only need to double (or quadruple) the options vega, and then subtract that value from the option price.

To see how the 148 call would respond to a 2% decrease in implied volatility, just double the vega, and subtract that number from the price (2.63-0.14= 2.49).

To learn more about vega, please check out our video below!

Option Greeks Summary

By this point, you should have a working understanding of how the Greeks can be helpful to you as an options trader. In conclusion, let’s review a few of our key terms.

Option Delta: Measures how an option responds to changes in the underlying price.
Option Gamma: Measured the acceleration at which an options delta changes.
Option Theta: Measures how the price of an option changes with a one-day advancement to expiration.
Option Vega: Measured the sensitivity of an option to changes in implied volatility.

Next Lesson

Additional Resources

Options Delta – The Greeks – CME Group

Options Vega – The Greeks – CME Group

Options Theta – The Greeks – CME Group

Bullish vs Bearish

Origins of Bullish and Bearish

Bullish

Bearish

Bullish and Bearish Sentiment

Market Neutral

Long vs Short

Origins of Long and Short

Long

Short

Short Selling Example

GameStop and Short-Selling

Short Selling = Infinite Risk

Exceptions to the Rule

Option Trading for Beginners

Final Word

Recommended Articles

Additional Resources

American Style (SPX) vs European Style (SPY)

Cash Settled (SPX) vs Physical Delivery (SPY)

A Lesson on the Dangers of Assignment

Tax Advantages of SPX over SPY

SPY vs SPY: Notional Value and Flexibility

SPX Option Prices

SPY Option Prices

Liquidity

Conclusion

SPX vs SPY: FAQs

Next Lessons

Additional Resources

Short Put Option Definition

Short Put Option Inputs

Short Put Option Profile

Long Put Option Explained

Long Put Option Example

AAPL Long Put Contract

Short Put Option Introduction

AAPL Short Put Contract

Maximum Profit in Short Puts

Maximum Loss in Short Puts

Short Put Options: Choosing a Strike Price

QQQ Put Options and Delta

Delta and In-The-Money Odds

Short Put Options and Time Value

QQQ Put Options and Days to Expiration

Short Put Options and Market Volatility

Short Put Options and Stock Volatility

LMT Put Options

Bill Put Options

Comparing Implied Volatility in Options

Selling Put Options and The Greeks

Short Puts & The Greeks

Historical Performance of Selling Put Options

Closing Short Put Options

Final Word

Next Lesson

Additional Resources

Payment for Order Flow Example

Payment for Order Flow: A Benefit to Retail Traders?

Markets Without Payment for Order Flow

PFOF Ban: Win-Win for Hedge Funds?

PFOF: What's the Solution ?

Next Lesson

Options Trading for Beginners

Long Put Options Explained

Delta Hedging Explained

Additional Resources

Out-Of-The-Money Options at Expiration

Out-Of-The-Money Option at Expiration Example

Out-Of-The-Money Calls vs Puts at Expiration

Worthless Options Post Expiration

At-The-Money Options at Expiration

At-The-Money Option at Expiration Example

At-The-Money Options and Pin Rsk

In-The-Money Options at Expiration

In-The-Money Call Options at Expiration

In-The Money Put Options at Expiration

American vs European Style Options

European Style Options Explained

Final Word