Open Interest vs Volume in Options Explained

Posted on January 26, 2022May 9, 2022 by Mike Martin

Last updated on May 9th, 2022 , 11:24 am

One of the things every options trader should do before entering a position is gauge the amount of trading activity in the options they wish to trade. Failing to run a quick liquidity check can leave an options trader stranded in a position, forced to exit at an unfavorable price.

Two metrics that every options trader should look at before entering a position are volume and open interest.

Care to watch the video instead? Check it out below!

What is Option Volume?

An option’s volume is the total number of contracts that have been traded on that trading day. For example, if an option has a daily volume of 15,000, then 15,000 contracts of that option have traded on that particular trading day.

The following chart shows the estimated total number of option contracts that were traded for various products over 1 year:

As we can see here, almost a billion option derivatives were traded among the top four products in the options markets, which indicates SPY, VIX, QQQ, and IWM options are very actively traded. With that said, every product included in the above chart is very actively traded.

Next, we’ll talk about open interest.

What is Open Interest?

In the stock market, an option’s open interest represents the total number of contracts that are “open” between any two parties. In other words, open interest is the number of option contracts that have been opened, but not yet closed. Let’s run through a basic example to demonstrate how open interest works.

Open Interest Example

Consider the following trade orders that are routed by two different traders, but on the same option contract:

Here, Trader A is buying-to-open 5 contracts to open and Trader B is selling 5 contracts to open. Both of these simple trading strategies are new positions.

If both traders are filled on their orders, the option’s open interest will increase by 5 because two traders have opened positions in that contract.

What happens when one of the traders closes their position while another trader opens a position? Consider the following trades:

As we can see here, Trader B bought 5 contracts to close while Trader C sold 5 contracts to open. In this case, open interest remains at 5 because there are still 5 contracts open between Trader A and C. However, if Trader A sells 5 contracts to close and Trader C buys 5 contracts to close, open interest will decrease by 5:

So, open interest represents the number of option contracts that are open in the market between two parties, though you don’t need to be concerned about the specific parties.

In summary, open interest increases when two parties get filled on opening orders, and decreases when two parties get filled on closing orders. When one party has an opening order and the other has a closing order, opening interest will not change (assuming both orders have the same number of contracts).

The Importance of Option Liquidity

An option’s volume and open interest are very important to you as an options trader because you do not want to get caught trading illiquid options (low volume and low open interest). Illiquid options tend to have wide bid-ask spreads, which can single-handedly wipe out a trading account over time.

Additionally, it’s harder to get out of option positions at good prices when volume and open interest are low, which means losses may grow larger due to the inability to exit a position.

What are ideal levels of volume and open interest? At the bare minimum, the options you use for your positions should have volume in the hundreds and open interest in the thousands:

Minimum Daily Volume: 100s, preferably 1,000s.

Minimum Open Interest: 1,000s.

At this point, you understand the basics of volume and open interest, and why they’re important to you as an options trader. In the next section, we’ll go over which options on a stock tend to have the most of each.

Which Options are the Most Liquid?

So, you know what option volume and open interest are, but which options tend to have the highest of each? To answer this, we’re going to run through some data on two of the market’s most actively traded products: the S&P 500 ETF (SPY), and Apple Inc. (AAPL).

First, we’re going to compare the volume and open interest of SPY options at each strike price on a single trading day. Then, we’ll look at different expiration date cycles.

To analyze the volume and open interest based on the strike price, we chose a day from earlier this year and plotted the volume and open interest of calls and puts at each strike price. We used the expiration cycle with approximately 50 days to expiration. Let’s take a look:

Regarding volume, we can see that the most actively traded options are the ones with strike prices near the stock price (at-the-money options). Less and less trading volume tends to occur in the options that are further away from the stock price.

Regarding open interest, we can see that even strike prices (185, 190, 195, etc.) have the highest open interest (and higher volume), suggesting that market participants prefer to trade even strikes as opposed to uneven strikes (187.5, 192.5, etc.).

So, options with strike prices close to the current stock price tend to be the most actively traded. Additionally, options with even strike prices tend to have the highest open interest because market participants prefer even strikes over uneven strikes.

Next, we’ll compare the volume and open interest across multiple expiration cycles.

Option Liquidity vs. Time to Expiration

In this next section, we’ll use SPY and AAPL options to analyze the volume and open interest across multiple expiration cycles. In both examples, we chose a day earlier this year and analyzed the volume and open interest for multiple expiration cycles. Let’s start with SPY:

Here, we can see that the near-term expiration cycles clearly have the highest volume and open interest compared to the longer-term expiration cycles. In this case, the 46-day expiration cycle has the highest open interest but not the highest volume. This could be caused by traders closing near-term option positions, therefore lowering the open interest in the short-term cycles.

AAPL Volume and Open Interest

Let’s take a look at AAPL’s options to see if the same trend exists:

In the case of AAPL, the near-term expiration cycles have the highest amount of volume, but there is still a significant amount of open interest in the longer-term expiration cycles. Some possible explanations are that more traders have longer-term theories regarding AAPL, or that more traders are using longer-term cycles for stock replacement strategies.

In most stocks, the option volume and open interest will be greatest in the near-term option cycles (less than 100 days to expiration). Additionally, the options with strike prices near the stock price (at-the-money) tend to have the most overall trading activity.

Understanding these key points can help you stay in liquid products, which will benefit you by keeping your “hidden” trading costs low, as well as ensuring you’ll be able to exit a position more easily if it moves against you.

Next Lesson

Additional Resources

Open Interest vs. Volume: Investopedia

The Bid-Ask Spread Explained: Options Trading 101

Posted on January 26, 2022May 2, 2022 by Mike Martin

Last updated on May 2nd, 2022 , 11:48 am

Bid-Ask Spread Definition: In the stock market, the “bid-ask spread” is the difference between the bid price and ask price for a security.

In this guide, you’re going to learn about the bid-ask spread, which is a crucial liquidity metric that should be examined before trading any stock or option (derivative). If you’d like, you can skip to a particular section by clicking on the section title.

Care to watch the video instead? Check it out below!

"Bid and "Ask" Explained

Before trading any product in the market, it’s crucial to gauge the hidden cost (in addition to transaction cost) of entering and exiting a position in that product. The bid-ask spread can be used to assess the cost of trading a particular stock or option.

Before discussing the bid-ask spread, we need to talk about what the “bid” and “ask” prices are. The following visual explains what the bid and ask prices represent.

When trading a share of stock or an option, you can get filled on your order immediately if you sell at the bidding price or buy at the asking price. Therefore, the bid-ask spread tells you how much money you would lose if you purchased something at the asking price and sold it at the bidding price (sometimes referred to as “slippage”).

In this case, you’d have to buy at $3.50 or sell at $3.00 to get filled immediately. When purchasing at the ask and selling at the bid (or vice versa), the corresponding loss will be $0.50, which translates to $50 for 100 shares of stock or 1 option contract.

Ideally, you want to lose as little as possible when entering and exiting a position, which means trading products with a narrow bid-ask spread is preferred.

Bid and Ask Spread: Market Makers

The function of a market maker is to provide market liquidity. These financial professionals accomplish this by standing ready to both buy the bid price and sell the asking price for the security they specialize in.

They profit from the “spread”, or the difference between the bid and ask price. However, they are obligated to fill you at the best price.

Market makers provide liquidity on particular securities on various stock exchanges, such as the NYSE and the Nasdaq.

Market makers want retail order flow so paid, they are willing to pay brokers for the right to fill their customers orders in a system called payment for order flow.

Bid and Ask Spread Example

As an example, let’s look at some hypothetical bid-ask spreads for various trading products:

If a trader wanted to purchase a share of stock instantly, they would have to pay the asking price of $100.03. To immediately get out of the position, they would have to sell at the bid price of $100.02. As you can see, the loss on this transaction is $0.01 per share (not including commissions). With 100 shares, the loss would be $1 ($0.01 x 100). A $0.01 bid-ask spread is the best-case scenario and is an indication that a product is actively traded.

Now, regarding the call option, the asking price is $1.20 higher than the bid price, which means a trader would lose $120 from just buying the call at the asking price of $6.30 and selling the option at the bidding price of $5.10. Trading products with a bid-ask spread this wide is clearly not advised.

Lastly, the put option has a bid-ask spread of only $0.05, which is considered to be a narrow spread. In the case of buying at the asking price and selling at the bidding price, a trader would only lose $5 per contract.

Spread in Stocks vs. Options

When trading shares of stock, the bid-ask spread will often be a few pennies wide. However, a majority of stocks have illiquid options with wide bid-ask spreads. So, be more aware of the bid-ask spread when transacting in the option markets, and try to only trade options with bid-ask spreads less than $0.10, as it will save your trading account from “hidden” costs that can accrue to massive amounts over time.

At this point, you know and understand the implications of the bid-ask spread. Next, we’ll quickly discuss which options tend to have the widest bid-ask spreads so you can avoid trouble when trading options.

Which Options Have the Widest Bid-Ask Spreads?

Options with strike prices further away from the stock price typically have wider bid-ask spreads.

To visualize this, we plotted a snapshot of the closing bid-ask spreads for calls and puts on SPY (S&P 500 ETF), which is an ETF that has one of the most actively traded option markets. We used options from early 2022 that had approximately 60 days to expiration:

As we can see here, in-the-money calls and puts have the widest bid-ask spreads (approximately $0.50 for the deep-in-the-money options). The options with the narrowest bid-ask spreads are the at-the-money options (strike prices near $205), and the out-of-the-money options. However, it’s worth noting that the out-of-the-money options have narrower bid-ask spreads because the option prices are cheaper (a $0.05 option couldn’t have a $0.50 bid-ask spread).

Bid-Ask Spreads of Long-Term Options (LEAPS)

Now, let’s look at the bid-ask spread of the same strike prices in the expiration that’s nearest to 365 days to expiration:

Right off the bat, we can see that the at-the-money 365-day options have a bid-ask spread near $0.20. These long-term options are known as “LEAPs”. The same options with 60 days to expiration had bid-ask spreads near $0.05. Regarding the in-the-money options, the bid-ask spread is slightly narrower in the 365-day options, which could be explained by higher trading volume in the long-term in-the-money options. Either way, it’s clear that the minimum bid-ask spread is four times wider in the 365-day options than in the 60-day options.

Spreads vs. Market Volatility

As mentioned previously, bid-ask spreads widen when market volatility picks up. To illustrate this, we plotted the average at-the-money bid-ask spread of SPY options on each day between August 3rd, 2015, and September 18th, 2015. We used the September 2015 expiration cycle:

As we can see, there’s a clear relationship between market volatility (as indicated by the VIX Index) and the bid-ask spreads of options on SPY. While only SPY is used as an example in the visual above, the same concept applies to other stocks in the market as well.

In this example, it’s important to note that the bid-ask spread increased from $0.025 to $0.15 as market volatility increased, but these were the closing bid-ask spreads. When the market opened on August 24th, the bid-ask spreads of SPY options were between $2.00 and $5.00 because the market had opened down 5%. However, the spreads narrowed throughout the day.

So, if you find yourself in a situation where the market is going to open significantly lower than the previous day, expect the bid-ask spreads to be wide in the first couple hours of the trading session.

What Is The Effective Spread?

Generally speaking, the bid and ask prices you see listed for a particular security are not the true market. This is often a wider spread than the true spread. You can often fill trades (particularly option trades) better than the listed market price.

This is because of price improvement.

The below formula (from Wikipedia) shows the equation to compute the “effective spread”.

Option Order Types

There are four primary types of option orders:

Limit orders ensure both buy price and sell price, but not execution. These order types are not filled until your “limit price” is reached. To get filled fast, limit orders set at the midpoint are recommended.

Market orders ensure that you will be filled immediately. You will sometimes buy at the lowest ask price and sell at the highest bid price in a market order. These order types are dangerous in options trading, especially in less liquid options.

Stop-loss orders trigger a market order when your stop price is breached.

Stop-limit orders trigger a limit order when your stop price is breached.

Bid-Ask Spread FAQs

Is a high bid/ask spread good?

Ideally, you want a very tight bid-ask spread. With a wide bid-ask spread, you will forfeit the difference between these two prices when entering and exiting positions.

If an option is bid at 1.20 and offered at 2, you will lose that 0.80 in value when you enter and then later exit the trade. Tight bid-ask spreads make for more efficient markets.

Do spreads count as day trades?

Spreads do indeed count as day trading. The more legs you have in your spread, the more transactions you will have. Day trading spreads in accounts under 25k are not recommended as this is the threshold to become a pattern day trader.

Next Lesson

Additional Resources

The Basics of the Bid-Ask Spread – Investopedia

Intrinsic & Extrinsic Value Explained (Options Trading)

Posted on January 26, 2022February 10, 2022 by Mike Martin

Last updated on February 10th, 2022 , 06:55 pm

Every options contract has a price, and this price consists of two components:

Here’s a quick visualization of an option’s price components:

TAKEAWAYS

Intrinsic value is the value of being able to buy or sell shares at the option’s strike price as opposed to the current stock price.
At expiration, an option will have only intrinsic value (or no value).
Extrinsic value represents all premium that is not intrinsic value.
Extrinsic value is comprised of “time value” and “implied volatility”.
Options deeper in-the-money have more intrinsic value and less extrinsic value
Out-of-the-money options are all extrinsic value.

What are Intrinsic and Extrinsic Value?

An option’s intrinsic value can be conceptualized as the value of being able to buy or sell shares at the option’s strike price as opposed to the current price of the shares. For example, if a stock is trading for $75, a call option with a strike price of $50 has $25 of intrinsic value. This is because the ability to purchase shares $25 below the market price should be worth at least $25.

On the other hand, with the stock at $75, a call option with a strike price of $75 has $0 of intrinsic value because exercising the call has no “real” value, as the investor can buy shares for $75 without using an option.

Intrinsic and Extrinsic Value at Expiration

At expiration, an option’s price will only consist of intrinsic value. Therefore, an alternative definition of intrinsic value is what the option will be worth at expiration (if the stock price were at its current price).

An option’s extrinsic value is the portion of an option’s price that exceeds its intrinsic value. From the previous example, if the call option with a strike price of $75 is trading for $5, its extrinsic value is $5. This is because the option has no intrinsic value, which means any value it has is extrinsic.

Why would an option with no intrinsic value be worth anything? Well, there’s a chance that the option ends up being valuable by the time it expires. An option’s extrinsic value is essentially the price associated with the potential for an option to become more valuable before it expires.

At expiration, options with only extrinsic value will be worthless. So, an option’s intrinsic value will always remain, but the extrinsic value will decrease as expiration approaches, as the option’s real value becomes more certain. For the reasons mentioned here, extrinsic value is often referred to as an option’s “time value.”

Now that you’ve learned the very basics of an option’s price components, let’s walk through and visualize how they relate to call and put options.

Intrinsic Value of Call Options

The intrinsic value of a call option is equal to the value of buying shares at the call’s strike price as opposed to the market price. For example, on a $150 stock, a call option with a strike price of $140 has $10 of intrinsic value because buying shares $10 below the market price should be worth at least $10 per share.

If the stock price is below the call’s strike price, then the option has no intrinsic value because a call trader has no benefit of buying shares at the strike price, as they can buy shares directly for a lower price. Consequently, any value the option has is extrinsic.

If the stock is trading above the call’s strike price, the call’s intrinsic value can be calculated with the following formula:

If the stock price is below the call strike, the intrinsic value is zero. An option will never have a negative intrinsic value, so the formula above only applies if the stock price is above the call’s strike price.

Call Option Example

Alright, let’s look at some visual examples of a call’s price components through time. First, we’ll look at an option that has intrinsic value (in-the-money) for most of the time. Then, we’ll finish by looking at a call option that consists of all extrinsic value through expiration.

In the following visual, we’ll look at the price of a stock (top), and a call option (bottom) with a strike price of $105. Be sure to compare the changes in the option’s intrinsic and extrinsic value as the stock price changes.

As you can see, when the stock price is above the strike price of 105, the call has intrinsic value. As the stock price increases further above the strike price, the call’s value shifts from extrinsic value to intrinsic value. Lastly, the call’s extrinsic value withers away as expiration approaches, leaving only intrinsic value in the call’s price at expiration.

Next, we’ll look at a similar example, except this time with an out-of-the-money call.

Intrinsic vs. Extrinsic: Out-of-the-Money Call Option

In this example, we’ll compare a stock’s price to a call option with a strike price of $195. Like before, examine the relationship between changes in the stock price and the call’s intrinsic and extrinsic value.

As demonstrated here, the stock price traded below the call’s strike price of $195 for almost the entire period. Consequently, the call’s price was purely extrinsic. As expiration approaches, the extrinsic value decreased to $0, leaving the call worthless at expiration.

In summary, call options have intrinsic value when the stock price is above the strike price. As the stock increases further above the strike price, the call’s price shifts from extrinsic value to intrinsic value. Lastly, any extrinsic value will experience time decay, or “theta“, as expiration approaches.

Intrinsic Value of Put Options

The intrinsic value of a put option is equal to the value of selling shares at the put’s strike price as opposed to the market price. For example, on a $50 stock, a put option with a strike price of $55 has $5 of intrinsic value because the ability to sell shares $5 above the current market price should be worth at least $5.

If the stock price is above the put’s strike price, the option has no intrinsic value. This is because the put owner has no benefit of selling shares of stock at the strike price, as they can sell shares for a higher price in the open market. Consequently, any value the option has consists of extrinsic value.

If the stock price is below the put’s strike price, the put’s intrinsic value can be calculated with the following formula:

If the stock price is above the put’s strike price, then the option’s intrinsic value is zero. An option will never have negative intrinsic value, so the formula above only applies when the stock price is below the put’s strike price.

Alright, let’s look at some visual examples of a put’s intrinsic and extrinsic value in action. First, we’ll look at an option that has intrinsic value (in-the-money) for most of the time. Then, we’ll finish by looking at a put option that consists of all extrinsic value through expiration.

Intrinsic vs. Extrinsic Value: In-the-Money Put

In the following visual, we’ll look at the price of a stock (top), and a put option (bottom) with a strike price of $190. Be sure to compare the changes in the put option’s intrinsic and extrinsic value as the stock price changes.

As demonstrated here, when the stock price is below the put’s strike price of $190, the put has intrinsic value. As the stock price decreases further below the strike price, the put’s value shifts from extrinsic value to intrinsic value. Lastly, the put’s extrinsic value decays away as expiration approaches, leaving only intrinsic value in the put’s price.

Next, we’ll look at a similar example, except this time with an out-of-the-money put.

Intrinsic vs. Extrinsic Value: Out-of-the-Money Put

In this example, we’ll compare a stock’s price to a put option with a strike price of $80. Like before, examine the relationship between changes in the stock price and the put’s intrinsic and extrinsic value.

Unfortunately, the put in this example never had any intrinsic value, as the stock price was always above the put’s strike price of $80. Consequently, the put’s price consisted of all extrinsic value. As expiration approached, the extrinsic value decreased to $0, leaving the put worthless at expiration.

In summary, put options have intrinsic value when the stock price is below the strike price. As the stock decreases further below the strike price, the put’s price shifts from extrinsic value to intrinsic value. Lastly, any extrinsic value will decay away as expiration approaches.

So, you’ve learned the basics of intrinsic and extrinsic value, and have also seen some specific demonstrations with calls and puts. At this point, you may be wondering what determines how much extrinsic value an option has. Well, you’re in luck, because that is the topic of the next section!

What Determines an Option's Extrinsic Value?

An option’s extrinsic value depends on a few factors:

1) Whether the option is in-the-money, at-the-money, or out-of-the-money.

2) How much time the option has until it expires.

3) The implied volatility of the options

First, options that are further in-the-money have more intrinsic value and less extrinsic value, and was visually demonstrated in the previous sections. As an option becomes further in-the-money, its value will shift towards intrinsic value.

At-the-money options will have the most extrinsic value of any option, while out-of-the-money and in-the-money options have less extrinsic value the further the strike price is from the stock price.

Second, options with more time to expiration are more expensive, and therefore have more extrinsic value than options at the same strike price with less time to expiration.

Option Value and DTE

In the following visual, we’ll compare four call options on the S&P 500 ETF (SPY) with varying days to expiration (DTE). With the SPY at $216, we’ll look at the 216 call in each respective expiration cycle. Let’s take a look!

As you can see, longer-term options at the same strike price are more expensive, and therefore have more extrinsic value. This is because there is more time left until the option expires, and therefore more time for the option to increase in value due to stock price changes.

Lastly, options on higher implied volatility stocks have more extrinsic value. To validate this, let’s look at the 100 calls with 30 days to expiration on three stocks that are trading for $100. Note how the higher option prices indicate higher implied volatility.

Why is this? Option prices determine implied volatility. When the future movements of a stock’s price are expected to be volatile, market participants are willing to pay more for protection, or to speculate on those movements (in other words, supply/demand leads to higher option prices, and therefore implied volatility).

All else being equal, if you look at two similarly-priced stocks, the stock with more expensive options will have higher implied volatility.

Next Lesson

Additional Resources

Option Value – How Are Options Priced? | tastytrade

When Do Options Expire? | Options Expiration Explained

Posted on January 26, 2022May 3, 2022 by Mike Martin

Last updated on May 3rd, 2022 , 10:27 am

Options Expiration Date: All options (equity, index, and ETF) have an expiration date. After this date and time, the derivative can no longer be traded.

Unlike shares of stock, options cannot be held forever. An option’s expiration date represents the final day that the option can be traded before settling to its final value. Standard options that are in-the-money (ITM) at expiration will expire to long or short shares of stock, or cash if the options are cash-settled. Options that are out-of-the-money (OTM) at expiry will expire worthless.

Care to watch the video instead? Check it out below!

TAKEAWAYS

All option contracts will eventually expire.
After this date, options with strike prices that are in-the-money are assigned/exercised for stock
Worthless options at expiration are rendered null; no action is required.
Most traders prefer to trade short-term options with under 100 days until expiration.
Liquidity should be considered before trading an option. This includes the spread, volume, and open interest.

Option Expiration

The following table summarizes what standard equity call options and put options settle to at expiration:

Option Type	Long / Short	ITM / OTM?	Option Settlement
Call	Long Short	ITM ITM	+100 Shares of Stock -100 Shares of Stock
Put	Long Short	ITM ITM	-100 Shares of Stock +100 Shares of Stock
Call or Put	Long or Short	OTM	$0 (Worthless)

After each option’s expiration date, the stock option can no longer be traded. From a trader’s perspective, expiring options will seamlessly disappear from the account, replaced by the corresponding stock position if the option expires in-the-money.

Now that you know the various outcomes for equity options at expiration, let’s discuss the specific days that options expire.

When Do Options Expire?

Standard options expiration occurs on the third Friday of each month. As a result, the last day to trade options in the standard monthly cycles is the third Friday of each month, which will be between the 15th and 21st day of the month. If the third Friday of the month falls on a market holiday, then the final day to trade the standard monthly options will be Thursday of that same week.

Any expiration date that isn’t on the third Friday of the month is considered to be non-standard, which includes weekly and quarterly expiration cycles. Weekly expiration cycles typically expire every Friday, except during the weeks of quarterly expirations.

The following table summarizes the various expiration types you’ll encounter when trading equity options:

Expiration Type	Last Day to Trade	Standard or Non-Standard
Monthly	Third Friday of Each Month	Standard
Weekly	Every Friday, Except Quarterly Expiration Weeks	Non-Standard
Quarterly	Last Trading Day of March, June, September, and December	Non-Standard

What's the Longest-Term Options Expiration Date?

As an options trader, you’ll always be able to choose from expiration cycles of varying durations. The shortest-term expiration cycle will, of course, be 0 days (expiring that same day), while the longest-term expiration cycle (LEAPs) will typically be approximately two years away.

As an example, here were all of the available expiration cycles for Apple Inc. (AAPL) options as of December 9th, 2016:

As you can see, there are 16 listed expiration cycles. You may notice that the weekly cycles are more present in the near-term, while the longer-term cycles are primarily monthlies. Longer-term expirations will typically consist of standard monthlies because weeklies aren’t listed until a few weeks before their expiration dates.

Alright, so you know what an option’s expiration date is, but how do you choose which one to trade in? In the next section, we’ll discuss how you can go about choosing an options expiration cycle to trade.

How to Choose an Option Expiration Cycle

With so many available expiration cycles, how do you decide which one to use? When choosing an expiration cycle to trade, there are two factors to consider:

1) The options strategy you plan on trading

2) The amount of trading activity in the expiration cycle you’re considering (gauged by volume and open interest)

Let’s run through each of these considerations one-by-one.

Consider Your Strategy

Most of the time, options expiration cycles with less than 100 days to expiration will be used because most options traders have short-term predictions for the stock price or implied volatility.

Additionally, traders who primarily sell options may prefer staying in near-term expiration cycles because short premium strategies profit from time decay, which is virtually non-existent in longer-term options.

Conversely, traders who primarily buy options may also prefer shorter-term expiration cycles because short-term option premiums are less expensive and more responsive to changes in the stock price.

Then who trades long-term options? Well, a common way to utilize longer-term expiration cycles is by purchasing deep-in-the-money calls or puts to replicate long or short stock positions. By purchasing long-term, deep-in-the-money calls or puts, traders can minimize losses from the decay of an option’s extrinsic value while gaining exposure to shares of stock with a lower margin requirement (more leverage).

Consider Liquidity / Trading Activity

The second consideration, and perhaps the most important one, is the amount of trading activity in the expiration cycle. Trading activity can be gauged by option volume and open interest for a particular stock. You’ll learn about volume and open interest in-depth in one of the following guides, but for now all you need to know is that more volume and open interest is a good thing.

As mentioned previously, most traders prefer to trade short-term expiration cycles, which means the most option volume and open interest will be in the near-term cycles. Additionally, standard monthly expiration cycles will typically have far more volume and open interest than weekly cycles.

To validate this, we compared the open interest and volume in each of AAPL’s expiration cycles from the table in the previous section. Here were the results:

As we can see, the highest open interest values are in the standard monthly cycles. Additionally, the first two standard options expirations have significantly more open interest than any of the longer-term cycles (with the exception of the 406-day expiration).

What about the amount of option volume? Let’s take a look:

In this case, the weekly cycle with 0 days to expiration (expiring that same day) had the most option volume, which makes sense because many traders adjust or close their positions on the day of expiration. Considering only standard options expirations, we can see that the first two monthly cycles have by far the most volume.

American vs European Option at Expiration

European options are cash-settled while American options are settled via the underlying stock.

All index options are European style. Trading these options greatly reduces risk because European-style options do not allow for early exercise.

Final Word

So, what does it all mean? Well, trading the two nearest standard monthly expirations benefits options traders in terms of entering and exiting positions fluidly. However, if your strategy is built for longer-term or weekly expiration cycles, then of course you’ll have to use those.

📅 CBOE 2022 Option Expiration Calendar

Option Expiration FAQs

What time do options expire on expiration date?

The vast majority of options stop trading at the closing bell on expiration day. There are some exceptions to this rule for ETF and index options. All equity options (stock options) seize trading at the bell.

Do options expire at open or close?

Most all options expire at the market close. Some index options, however, expire at the market open. These are called “AM” options.

Do options expire automatically?

Options expire automatically at the close for the option expiration date listed in the contract. In-the-money options will be assigned and exercised while out-of-the-money options will simply be removed from the account.

Next Lesson

Additional Resources

Options Expiration Calendar 2022 – MarketWatch

What is an Option’s Strike Price? | Options Guide w/ Visuals

Posted on January 26, 2022February 22, 2022 by Chris Butler

Last updated on February 22nd, 2022 , 10:03 am

TAKEAWAYS

Long call options have the right to purchase 100 shares of the underlying stock at the contract’s strike price.
Long put options have the right to sell 100 shares of the underlying stock at the contract’s strike price.
Short options are at the mercy of longs and must deliver this stock at the strike price when/if the long chooses to exercise their contract.
All options exist in one of three moneyness states: in-the-money, at-the-money or out-of-the-money
At higher strike prices, put options are more expensive.
At lower strike prices, call options are more expensive.

All options represent the right the buy (for call owners) or sell (for put owners) 100 shares of stock at a certain price, on or before the option’s expiration date. Traders who are short options have an obligation to sell (for call sellers) or buy (for put sellers) 100 shares of stock at a specified price if assigned to an exercise notice.

An option’s strike price indicates the purchase/sale price of 100 shares of stock (per option contract) in the event that the option buyer exercises or the option expires in-the-money.

Let’s take a look at what a real option chain looks like and go through some examples of what the strike prices represent:

Stock Price at $120

Call Price	Strike Price	Put Price
$12.07	110	$1.91
$5.90	120	$5.74
$2.36	130	$12.20

As you can see, there are numerous strike prices for every call and put. The following table summarizes what each of these strike prices represents for option buyers (assuming one option contract):

Long Option Exercise

Call Price	Call Buyer's Right Upon Exercising:	Put Buyer's Right Upon Exercising:
110	Buy 100 shares for $110 per share.	Sell 100 shares for $110 per share.
120	Buy 100 shares for $120 per share.	Sell 100 shares for $120 per share.
130	Buy 100 shares for $130 per share.	Sell 100 shares for $130 per share.

Conversely, the following table summarizes the obligations for call and put sellers at each strike price (assuming one option contract):

Short Option Assignment

Call Price	Call Buyer's Right Upon Exercising:	Put Buyer's Right Upon Exercising:
110	Buy 100 shares for $110 per share.	Sell 100 shares for $110 per share.
120	Buy 100 shares for $120 per share.	Sell 100 shares for $120 per share.
130	Buy 100 shares for $130 per share.	Sell 100 shares for $130 per share.

So, at this point you understand that an option’s strike indicates the price at which shares of stock will be bought or sold when an option is exercised. Regarding basics, this is all you really need to know about an option’s strike price.

However, you should also know how an option’s premium relates to its strike, which we’ll discuss in the next section.

Now that you know the basics of an option’s strike price, let’s discuss how an option’s strike price relates to the option’s premium.

Strike Price vs. Stock Price: ITM, ATM & OTM

Aside from representing the purchase or sale price when exercising an option, the relationship between an option’s strike price and the current stock price can help explain the price of the option.

More broadly, there are three terms that options traders often use to describe the relationship between an option’s strike price and the current stock price (which indicates whether an option’s price is likely to be expensive or cheap). The three terms are “in-the-money (ITM),” “at-the-money (ATM),” and “out-of-the-money (OTM).” Here’s how each of these phrases describes the relationship between the stock price and an option’s strike price:

In-the-money: Calls with strikes below the stock price; puts with strikes above the stock price.

At-the-money: Calls and puts with strikes equal to or near the stock price.

Out-of-the-money: Calls with strikes above the stock price; puts with strikes below the stock price.

As an example of what this looks like, let’s examine the same option chain from the previous section:

Stock Price at $120

ITM/ATM/OTM	Option Type	Strike Price	Option Type	ITM/ATM/OTM
ITM	Call	110	Put	OTM
ATM	Call	120	Put	ATM
OTM	Call	130	Put	ITM

As you can see, with the stock price at $120, both the $120 call and put are considered to be at-the-money, the 110 call and 130 put are both in-the-money, and the 110 put and 130 call are out-of-the-money.

Next, we’ll talk about how a call or put option’s strike price relates to the option’s price.

Call Option Strike Price vs. Premium

In the previous option chain tables, you may have noticed that at lower strike prices, call prices are higher. Conversely, call prices are lower at higher strike prices. Why is this?

Intuitively, call options with strike prices lower than the stock price should be more expensive because the ability to buy shares of stock for less than the current share price is valuable.

On the other hand, call options with strike prices higher than the stock price should be cheap because there is no “real” value in being able to buy shares for more than the current share price.

Consequently, in-the-money call options will be the most expensive (more expensive at lower strikes), and out-of-the-money call options will be the cheapest (closer to $0 at higher strikes). The following visual validates this concept using 70-day options on the S&P 500 ETF (SPY):

Next, we’ll examine the relationship between put option prices and their strike prices.

Put Option Strike Price vs. Premium

With a put option, the relationship between the strike price and premium is the opposite of calls: at higher strike prices, put options are more expensive; at lower strike prices, put options are cheaper.

The direct relationship between a put’s strike price and premium should make sense because the right to sell shares of stock for more than the current share price should be valuable.

Conversely, the ability to sell shares of stock for less than the current share price doesn’t have any “real” value, which explains why put options with strike prices below the stock price are 100% extrinsic/time value.

Like with calls, in-the-money puts will be the most expensive while out-of-the-money puts will be the cheapest (closer to $0 at lower strike prices). The following visual validates this concept using 70-day option prices on SPY:

Final Word

Very nice! You should now have a solid handle on how strike prices relate to calls and puts, as well as how the relationship between an option’s strike price and the stock price can be an indication of the option’s value (and why that relationship makes sense).

Next Lesson

Additional Resources

What Is the Strike Price of an Option? The Street

What Are Options? The Basics of Call & Put Options

Posted on January 26, 2022May 9, 2022 by Mike Martin

Last updated on May 9th, 2022 , 05:18 am

What are options? To give you the textbook definition, options are financial contracts that give the holder (buyer) the ability to buy or sell 100 shares of stock at the option’s “strike price” at or before expiration. The seller (writer) has the obligation to deliver those shares if they are assigned to an option holder’s exercise.

Before you learn about the two option types, let’s go over basic characteristics of options.

Strike Prices & Expiration Dates

Two characteristics that all options have are strike prices and expiration dates. We’ve written entirely separate guides on both, but for now it’s necessary to provide a brief definition of each.

1.) A strike price is the price that shares will be exchanged at if the option buyer exercises, or if the option is in-the-money and held through expiration. For example, if a trader owns a call option with a strike price of $50, the trader will effectively buy 100 shares of stock at $50 per share if they exercise the option (a valuable right to have when the shares are trading higher than $50).

On the other hand, the seller of the call option is obligated to deliver these shares if assigned, effectively selling 100 shares of stock for $50 per share (an unfavorable scenario when the shares are trading for significantly more than $50).

2.) In addition to a strike price, all options have an expiration date, which is the date each option stops trading and ceases to exist. This is one of the major differences between stocks and options. Stocks can be held forever, but at some point, options expire. Prior to expiration, traders with positions must decide whether they want to close their option position, or let it expire.

If a trader lets an option expire in-the-money, they will take on a stock position (unless the options are on a product with no tradable shares, such as the VIX or SPX). On the other hand, options that expire out-of-the-money simply disappear from the account, leaving the trader with any residual profits or losses from the worthless option.

Standard Option Contract Multiplier

The last basic option characteristic you need to know is called a contract multiplier. The real value of an option in dollar terms is the option’s price multiplied by the contract multiplier. A standard equity option contract has a contract multiplier of 100 because each option controls 100 shares of stock.

When you view an option’s price, the actual value of that option is the price multiplied by 100 (for standard equity options). For example, if you want to buy an option that’s quoted at $13.20, you’ll need $1,320 in your account to buy that option (not including commissions).

You’ve just learned the very basics of options. To bring it all together, every option has a strike price and an expiration date. Additionally, standard equity options have a contract multiplier of 100, which means the option’s value in dollar terms is the price multiplied by 100. Armed with this knowledge, it’s time to learn the basics of calls and puts!

First, we’ll cover call options. Then, we’ll finish with put options.

Call Option Basics

In this section, you’ll learn about call options. In order to accomplish this, let’s discuss calls from both the buyer and seller’s perspective.

Why would someone buy a call? Well, a call buyer benefits when the stock price increases to a price well above their option’s strike price. If the stock price does increase above the call’s strike price, the call option’s price increases, as the ability to buy shares at a much lower price becomes more valuable. Therefore, a trader who buys a call anticipates the stock price will increase.

Conversely, a call seller benefits when the stock price trades below the option’s strike price. If the stock does trade below the strike price, the call’s price will trade towards $0 as expiration approaches. As a result, the call seller will keep the premium (an option’s price is sometimes referred to as premium) they collected for selling the call. If the stock price increases above the strike price, the call seller is in trouble because as the stock price increases, the call becomes more and more valuable. When the option is worth more than the seller collected for it, they will have losses. Therefore, a trader who sells a call option anticipates the stock price will remain below the strike price.

Call Option Trade Example

Now that we’ve gone through both perspectives related to call options, let’s look at a visual example of how a call’s price changes when the stock price changes. In the following chart, we’ll analyze a call option with a strike price of $190. Be sure to compare the stock price to the call’s strike price, and see how that translates to a change in the call’s price.

What Are Options? Call Option Visualization

As illustrated here, when the stock price increases more and more above the call’s strike price of $190, the call option becomes more valuable. Now, if a trader had purchased the call option at the beginning of the period, they would have profits of about $1,500 (because the call is worth $15 more than the trader’s purchase price, and every $1 of an option’s price represents $100 in actual dollar terms).

On the other hand, the call seller would be sitting on $1,500 losses, as the contract is worth $15 more than they sold it for. In this example, the call option’s value increases because the ability to buy shares of stock at $190 gets more valuable as the stock price increases further above $190.

If this call option was held through expiration, a trader who owned the call option would be left with 100 shares of stock, with an effective purchase price of $195 per share ($190 strike price + $5 premium paid for the option). On the other hand, a trader who sold this call option would have -100 shares of stock (a short stock position of 100 shares), with an effective sale price of $195 per share ($190 strike price + $5 premium collected for the option).

Alright, now that you have the basics of call options down, let’s talk about put options!

Read! 29 Core Options Trading Strategies

Put Option Basics

Like we did for calls, let’s discuss put options from both the buyer and seller’s perspective.

Why would someone buy a put? A put buyer benefits when the stock price decreases to a price well below their option’s strike price. If the stock price does drop below the put’s strike price, the put option’s price increases, as the ability to sell shares at a higher price becomes more valuable. Therefore, a trader who buys a put anticipates the stock price will decrease.

Conversely, a put seller benefits when the stock price trades above the option’s strike price. If the stock price does remain above the put’s strike price, the put’s price will trade towards $0 as expiration approaches, and the put seller will keep the premium they sold the option for. If the stock price drops below the put strike, it’s bad news for the put seller. This is because as the stock price decreases, the put becomes more valuable.

The put seller will have losses for as long as the put is worth more than they premium they collected when entering the trade. Therefore, a trader who sells a put anticipates the stock price will remain above the strike price.

Let’s look at a visual to demonstrate these concepts!

Put Option Trade Example

In the following example, we’ll analyze a put option with a strike price of $95. Be sure to compare the stock price to the strike price of the put, and see how that translates to changes in the put’s value.

As demonstrated here, the put price increases when the stock price drops further and further below the strike price of $95. Why? Because the ability to sell shares at a higher price becomes more valuable as the share price decreases.

More specifically, the stock price dropping from $95 to $90 results in $300 in profits for the put buyer because the option’s value is $3 more than the trader paid for the option. Conversely, the put seller in this scenario would have $300 in losses, as the option is $3 more than they sold it for. However, at expiration, the put seller makes a $300 profit because the option expires out-of-the-money. On the other hand, the put buyer loses the full $300 they paid for the option.

At expiration, neither trader would have a stock position, as the option expired out-of-the-money. However, if a put option expires in-the-money, any trader who holds the option through expiration will end up with a stock position. For a trader who is short the put, the resulting position will be +100 shares per contract. Conversely, a trader who owns the put will have a position of -100 shares (a short stock position) per contract. The share entry price for both traders is the put’s strike price, less the amount the option was bought or sold for.

Additional Resources

What Are Options? – Forbes

What is Options Trading? The Ultimate Beginner’s Guide to Options

Posted on January 26, 2022February 10, 2022 by Chris Butler

Last updated on February 10th, 2022 , 07:05 pm

What is Options Trading? The Ultimate Beginner's Guide to Options

As someone who teaches options trading, the questions I get to hear the most are – “What is options trading?” and “how can I get started as a beginner?” Today, I’ll answer both.

Options trading might seem a very difficult thing to learn, as there are many moving parts and many concepts to learn simultaneously. In this blog, my goal is to bring you from zero to hero, even if you don’t know anything about options trading.

We are going to explore the world of options through various examples, graphical illustrations, and in-depth explanations simplified as much as possible. Our goal here is to provide you with an overview of the biggest options trading concepts and get you to a point where you understand those concepts intuitively.

Now since teaching the basics of options trading isn’t a job to be completed in one post, we decided to divide this into three parts. The first part that you’re reading right now covers all the basics regarding what options trading is, what the two option types are, and how they work.

TAKEAWAYS

Unlike stocks, all options eventually expire.
The “Strike Price” of an option is the price at which shares can be purchased (calls) or sold (puts) if that option were to be exercised.
One options contract almost always represents 100 shares of stock.
Call options profit in a bullish market.
Put options profit in a bearish market.
Option do not need to be exercised to make a profit.

What Are Options + Basic Characteristics

An option gives the buyer the right (not obligation) to buy or sell an underlying asset at a pre-determined price, between now and the expiration date. There are two types of options, a call option and a put option, we’ll talk about them in detail later.

Basic Option Characteristics:

1. All Options Expire

All options have an expiration date which makes it different from shares of stock. An option may expire in a week or 3 years. So when you are trading options, you have to choose a timeframe for your position. When investing in stocks, you don’t have a time limit. You can hold the shares as long as the company is publicly-traded. Options and stock differ widely.

2. All Options Have a “Strike Price”

The strike price is the price at which the options can be converted into shares of stock. In simple terms, it is the price at which you can buy/sell shares of stock if you “exercise” your option. Say you buy a call with a strike price of $105 and one week later the stock jumps to $120. You’ll still be able to buy the $120 stock at the strike price of $105 by exercising your call option. We’ll go through more examples in a bit.

3. The Option Contract Multiplier

A stock of $100 can be purchased with $100, but when it comes to option prices, you have to pay 100x the ‘listed price’ of the option. For example, say on the same $100 stock, the option price is shown as $5. You can’t purchase that option for $5 in cash, you’ll need to spend $500 on it. Why is this? Because most option contracts in the U.S. can be converted into 100 shares of stock, which is called the “multiplier.” This allows options great leverage. To calculate the actual value or “premium” of an option, multiply the listed option price by 100:

Characteristics of Options Shown in a Trading Software

Call Option With Example

The first option type is called a call option. A call option gives you the ability to buy 100 shares of a stock at the strike price of the option. Call option prices move with the stock price. When the stock price increases, the call price increases, and when the stock price decreases, the call price decreases as well.

This makes call options extremely profitable when the stock price increases above the strike price, and lose value when the stock price decreases below the strike price. Let’s take an example to get a better grasp of it.

Call Option "House" Analogy

Say there’s a house and the current value of it is $200,000. I am interested in buying the house because I think the value of the house will appreciate significantly in the coming years, however, I’m not ready to buy it in full right now.

What I’ll do instead is buy a “call option” on this house which gives me the ability to buy the house at the strike price of $200,000 anytime in the next 2 years. To buy this call option, I pay $10,000 in premium right now to lock in the deal. So here’s what it looks like:

House value: $200,000

Strike Price: $200,000

Option Expiration Period: 2 years from now.

Option Premium: $10,000

Now, only two things can happen 2 years down the line. Either the value of the house appreciates or depreciates over the two year time frame. Let’s say the former case turns out to be true and after 2 years, the house is now valued at $350,000. Quite a significant increase!

Since I still have the option in my possession, I can exercise the option and buy the house at its strike price of $200,000, making a sweet profit of $140,000 in the process.

Why $140,000? Because if I buy the house for $200,000 via my call option and the house is worth $350,000, I have a $150,000 gain on the difference between the market value of the house and my purchase price. But since I paid $10,000 for the option initially, the net gain is $150,000 – $10,000 = $140,000.

But what if the second case happens to be true and over the next 2 years, the house value depreciates to $150,000? Well, in that case, my call option becomes worthless because there’s no point in buying a $150,000 house at the $200,000 strike price. It’s an option, which means I don’t have to use it if I don’t want to. And if it does not provide any benefit to me, then I won’t use it. If the contract isn’t used and doesn’t have any real value at the time of expiration, I lose the entire premium paid for the option.

So what happens to my $10,000 premium that I paid? Whoever sold me the option keeps that as profit, and they also keep the house.

But keep in mind that if I purchased the house outright at its initial value of $200,000, I’d lose $50,000 if the house price fell to $150,000. With the option purchase, I only lose $10,000, even if the house price falls to $0.

The above description is exactly how options on stocks work, except a call option can be used to buy 100 shares of stock at the call’s strike price, not one house.

Put Option With Example

If you understood the concepts of call options thoroughly, then it will be a cakewalk for you to get put options. Because the basics are exactly the same except everything is flipped on its head.

A put option gives the buyer the ability to sell 100 shares of stock at the strike price on/before the expiration date.

Remember how call option prices move in the same direction as the stock price? Well with put options, its the opposite. When the stock price increases, the put option price decreases, and vice versa.

Don’t worry if you still don’t understand it, because we’re going to take an example which will make the concept crystal clear.

Put Options Example

Since we’ve already taken a hypothetical example with a house, now let’s take a real-life example with real stock.

Say INTC (Intel) closes at $50 showing a downward trend. A trader thinks that the trend will continue in the upcoming weeks and buys a put option in INTC with an expiration date in the next 2 weeks. The strike price of the put is $50, and the trader pays $2.50 to buy the option (a premium of $250).

After a couple of weeks, INTC actually loses value and ends up at $45. This will generate a profit for the trader because now their put option can be used to sell 100 shares of stock at $50/share, which is $5 higher than the current share price. Because of that, the put’s value will be at least $5.00, or have a premium of at least $500. In this scenario, the trader will have doubled their money from the decrease in the share price. The trader can simply sell the put option at the now higher price to secure profits on their options trade.

Let’s take another example but this time with a different stock, say NVDA (Nvidia) is trading at $485 and a trader buys a put option with a strike price of $485 in NVDA because they think the stock will sink in the future.

To their surprise, NVDA ends up climbing up to $500, and is well above the put option’s strike price of $485 on the expiration date. In this case, the put option that was bought by the trader earlier will become worthless. The trader would not want to sell a $500 stock at the strike price of $485, and the put option’s price would reflect the lacking value of that ability.

Do You Have to Exercise an Option to Make a Profit?

Till now, wherever we’ve talked about making a profit, we said you exercise the option to buy/sell shares at the option’s favorable strike price, producing a profit. But in real life when you trade options, you’ll almost never exercise an option to realize the profit because you don’t have to.

The reason we described the above examples like that is because as an options trader, you have to understand where the prices are coming from and why the price changes make sense. An option’s value is directly tied to its ability to buy/sell shares of stock at the option’s strike price, right now or in the future.

In reality, you never have to exercise the option to secure a profit. Because here’s the thing: an option will always include the benefit it provides to the owner in its price. In simple terms, the option price will embed any profit that can be made by exercising it. If I own a call option with a strike price of $450, but the stock price is at $500, the option can be used to make a $50 gain per share. This means the option’s price will be at least $50, or have a premium of $5,000 ($50 gain x 100 shares = $5,000 gain).

So when you want to take a profit on an option position, you don’t need to exercise it, you can just sell the option at its higher price to secure a profit. If you buy an option and pay $300 in premium for it, and its value increases to $500, you can sell the option and realize a $200 profit on the trade.

Final Word

That wraps it up for this part of our ultimate beginners guide to options trading. We hope we were able to explain to you what options trading is, what the option types are and how they work.

Additional Resources

What are Option’s? – Forbes

Options Trading Basics | 9 Simplified Guides w/ Visuals

Posted on January 26, 2022February 14, 2022 by Chris Butler

Last updated on February 14th, 2022 , 10:01 am

Learn the absolute essential options trading concepts!

Options Trading Explained

What is options trading?

Read Guide

Basics of Calls and Puts

Learn the basics of call options and put options.

Read Guide

What is a Strike Price?

Learn about an option’s strike price and “moneyness.”

Read Guide

Options Expiration

Learn about when options expire and how to choose an expiration.

Read Guide

Intrinsic & Extrinsic Value

Every option has two price components: intrinsic and extrinsic value.

Read Guide

Exercise & Assignment

What happens when an option is exercised?

Read Guide

The Bid-Ask Spread

Learn about gauging an option’s “liquidity” with the bid-ask spread.

Read Guide

Volume & Open Interest

Learn more about option liquidity with volume and open interest.

Read Guide

Order Types: Market, Limit, GTC, Stop-Loss

There are numerous order types you can use when trading stocks or options. Which ones are the best and which are the worst?

Read Guide

Option Theta (Time Decay) | The Ultimate Guide w/ Visuals

Posted on January 26, 2022April 15, 2022 by Chris Butler

Last updated on April 15th, 2022 , 08:31 am

Theta is the option Greek that measures the rate of change in an option’s premium in relation to the passage of time, typically one day.

Why is the passing of time a risk to an option’s trader?

Options are “decaying” assets, which means that option prices decrease over time (all else being equal). An option’s theta estimates how much the price of an option will decrease with the passing of one day.

Since options are decaying assets, theta benefits option sellers. Option buyers, however, require the underlying stock/ETF/index to move by a lot to capture the premium paid for theta.

For this reason, option contract sellers are said to be “positive theta” while option sellers are said to be “negative theta”. The net theta exposure for various options strategies will determine whether a position is positive or negative theta.

To explain why option prices decrease over time, let’s run through a few basic examples.

TAKEAWAYS

Theta is the option Greek that measures the sensitivity of an option’s price relative to the passage of time. This Greek is important for option traders as it represents the time value decline of options contracts.
The other four options Greeks are: 1) Vega (implied volatility risk), 2) Delta (underlying stock/ETF/index price movement risk), 3) Gamma (derivative risk derived from delta), and 4.) Rho (interest rate risk).
Long options are negative theta.
Short options are positive theta.
Theta increases as time decay picks up in the weeks leading up to expiration.

Option Decay: A Basic Example

As mentioned above, theta represents how much an option’s price should decrease by with the passing of one day. In the following table, work your way from left to right, and pay attention to how an option’s theta translates to the option’s expected price in the future.

Clearly, options with larger theta values are expected to decay more than options with lower theta values.

Why do option prices decrease over time? To understand why, let’s use a non-options example and bring it full circle.

Options as Insurance

Consider a 30-day insurance policy that you can buy on your house for $100. 30 days pass, and no damages have occurred to the house. Since the insurance policy’s coverage period has ended, and no damages can be claimed, the insurance policy is worth nothing. This means that in 30 days, the policy’s price decreased from $100 to $0.

Options are essentially insurance contracts that market participants can buy and sell on certain stocks. Consequently, when very little happens to the stock price, options experience the same price decay as the policy in the insurance example.

Theta and Intrinsic/Extrinsic Value

To be clear, only an option’s extrinsic value decays away as time passes. An option’s intrinsic value is the option’s real value at any given moment, and intrinsic value does not decrease with the passing of time.

Let’s look at some real examples so you can see option/theta decay in action.

Theta Decay Example: AAPL Call Options

To demonstrate theta decay, we’ll visualize an option’s price as its expiration approaches. Here are the specifics:

Stock: Apple Inc. (ticker symbol: AAPL)

Option: 105 Call (expired February 2016)

Time Period: January 7th to February 19th (2016)

To clarify, we analyzed the price of the AAPL call option with a strike price of $105, expiring in February of 2016 (standard expiration cycle). Let’s take a look!

In this visual, you are looking at the price of AAPL (top) compared to the price of the AAPL 105 call expiring in February (bottom). More specifically, the option’s price is dissected into intrinsic and extrinsic value.

In this specific example, the option is out-of-the-money the whole time, which means 100% of the option’s price is extrinsic value. As demonstrated here, the option’s extrinsic value decays away as time passes. At expiration, the option is worth $0. This is theta decay in action (just like the insurance example from earlier).

So, how does theta decay impact an option that has intrinsic value? Let’s take a look at an example!

Decay of an Option With Intrinsic Value

To demonstrate the decay of an option with intrinsic value, we’ll analyze all the same metrics as the previous example. This time, we’ll look at an example with a put option that expires in-the-money. Here are the specifics:

Stock: Tesla Motors (ticker symbol: TSLA)

Option: 230 Put (expired June 2016)

Time Period: April 1st to June 17th (2016)

When looking at this visual, pay attention to the relationship between the option’s price, intrinsic, and extrinsic value as the stock price changes and expiration approaches. Let’s take a look!

In this example, the 230 put had no intrinsic value initially. Over this period, theta decay kicked in and the option’s price decreased. However, TSLA kept falling, and eventually the option had intrinsic value when TSLA fell below $230.

As expiration approached, all of the extrinsic value decayed out of the option’s price. However, since the option had $15 of intrinsic value at expiration, the option was still worth $15.

So, between the AAPL and TSLA example, you have learned that theta decay only works against an option’s extrinsic value.

Additionally, it’s important to note that time decay generally does not occur exactly like an option’s theta suggests. This is because there are factors other than time that cause option price changes. So, don’t get hung up when theta decay doesn’t work perfectly on a day-to-day basis. Over longer periods of time, it will!

You’ve learned the basics behind the almighty “theta decay.” Now, the next time somebody talks about “decaying assets,” you’ll know what they’re talking about!

Alright, it’s time to dive in a little bit deeper. In the next section, you’re going to learn which options have the most exposure to time decay.

Which Options Have the Most Exposure to Time Decay?

So, you know that options decay, but which options have the most exposure to time decay? The answer to this is very straightforward: options that have the most exposure to decay are the ones with the most extrinsic value. This means at-the-money options in high implied volatility carry the greatest potential losses from theta decay.

The following table demonstrates the expected decay of in-the-money, at-the-money, and out-of-the-money options:

While the 150 call is the most expensive, most of its value is intrinsic, which we know does not decay! On the other hand, the 215 call only has $0.27 of extrinsic value compared to the 201 call. Therefore, at-the-money options have the most to lose from theta decay, since they are the most expensive options that consist of 100% extrinsic value.

To hammer this point home, let’s go through some visualizations to demonstrate which options have the most exposure to decay. First, we’ll analyze an in-the-money call, an at-the-money straddle, and a strangle. Then, we’ll compare options in high and low implied volatility underlyings.

In-the-Money Option Decay Example

The call example we’re going to look at is in NFLX. Here are the specifics:

Stock: Netflix (ticker symbol: NFLX)

Option: 90 Call (April 2015)

Time Period: March 1st to April 15th (2016)

Again, focus on the decay of the call’s extrinsic value. Let’s take a look!

As you can see, the 90 call is in-the-money the whole time as the market price of the underlying steadily rose, which implied the option’s price includes intrinsic value. A trader who owned this call would not have suffered too much from theta decay, as the stock price was moving in their favor and the option’s value was mostly intrinsic.

Now, let’s look at examples of positions that experienced plenty of time decay.

At-the-Money Time Decay Example

As mentioned earlier, at-the-money options have the most exposure to time decay, since their prices are all extrinsic. To illustrate at-the-money decay, we’ll examine a long straddle in Facebook. As a quick recap, a long straddle consists of buying an at-the-money call and put (all extrinsic!). Here are the specifics:

Stock: Facebook (ticker symbol: FB)

Option: 105 Straddle (expired January 2016)

Time Period: November 13th to December 31st (2015)

Let’s take a look at what happened!

As visualized in this example, the price of the underlying asset (FB) traded near the strike price of the straddle for 33 trading days. As a result, the straddle suffered continuous losses from time decay.

A trader who bought this straddle would have lost $600 per straddle over the period. On the other hand, a trader who sold this straddle would have had $600 in profits from the time decay. As you may have already picked up by now, theta decay is great for options sellers and the primary enemy of option buyers.

Let’s take a look at some out-of-the-money option decay!

Out-of-the-Money Time Decay Example

Lastly, we’re going to look at the decay of out-of-the-money options. Since the previous example in Facebook was such a great time period to demonstrate option decay, we’ll use it again. This time, you’ll get to see the performance of a strangle. Recall that a strangle consists of buying or selling an out-of-the-money call and put. Here are the specifics:

Stock: Facebook (ticker symbol: FB)

Options: 95 Put (expired January 2016), 115 Call (expired January 2016)

Time Period: November 13th to December 31st (2015)

Let’s see what happens!

As you can see, the 95 put and 115 call were never in-the-money over the entire period. Consequently, the value of the strangle was 100% extrinsic, and decayed away as time passed. In this example, a hypothetical trader who purchased the strangle suffered continuous losses from time decay.

Conversely, a hypothetical trader who sold the strangle experienced steady profits over the entire trade duration as the price of the underlying stayed steady. This is one demonstration of how traders get into trouble by purchasing out-of-the-money options.

How Option Decay Changes Over Time

In the final sections, we’re going to take your theta/option decay knowledge to the next level by getting a little more specific.

First, we’re going to talk about the difference between in-the-money, at-the-money, and out-of-the-money option decay.

Finally, we’ll end with a very important section that discusses instances in which options don’t decay as expected.

Like most things related to options, nothing is linear due to all of the moving parts. This is also true for an option’s rate of decay. The decay rate of an option may speed up or slow down as time passes. This depends on whether the option is in-the-money, at-the-money, or out-of-the-money.

In general, as expiration gets closer:

➜ At-the-money option decay tends to speed up significantly.

➜ Out-of-the-money option decay tends to slow down.

Acceleration of At-the-Money Time Decay

Let’s start with at-the-money time decay. To visualize at-the-money option decay into expiration, we ran a test. From January of 2007 to the end of 2016, we did the following:

➜ On the first trading day of each month, we selected the expiration cycle closest to 75 days away.

➜ Each subsequent trading day, we recorded the at-the-money straddle price in that expiration cycle. For example, if the stock was $200, we recorded the 200 straddle price. On the following day, if the stock was $190, we recorded the 190 straddle price in that same expiration cycle. This process was repeated until each respective expiration date was reached.

Overall, 118 expiration cycles were tested.

Once all of the prices were collected, we computed the percentage of each day’s straddle price relative to the starting straddle price. For example, if the at-the-money straddle was $10 on the first day (75 days to expiration), and 30 days later the at-the-money straddle price was $7, then the remaining extrinsic at 45 days to expiration would be considered 70%.

Lastly, we averaged the remaining extrinsic percentages across all 118 occurrences based on the number of days until expiration. Let’s take a look!

ATM = At-the-money

As illustrated here, the decay of at-the-money option prices accelerates as expiration gets closer and closer. More specifically, the rate of at-the-money decay was fairly slow from 75 to 60 days to expiration.

From 60 to 30 days to expiration, the rate of decay began to accelerate.

In the final 30 days, the rate of decay really picks up speed, with the steepest decay occurring in the final 5-7 days. Even more interesting, after 85 of the 90 days, the straddle still held on to 25% of its value, on average.

Deceleration of Out-of-the-Money Option Decay

As mentioned earlier, out-of-the-money options decay slower and slower as expiration approaches. Why is this? Near expiration, out-of-the-money options will be nearly worthless, which means the option doesn’t have much to lose in the first place.

To demonstrate the slowing decay of out-of-the-money options, we used a similar approach to the at-the-money decay study. Again, we used SPY options from January 2008 to April 2016, reaching 100 occurrences. Here’s what we did:

➜ On the first trading day of each month, we selected the expiration cycle that was closest to 75 days away.

➜ On that first day, we selected the 10-delta call and put strikes (10% probability of expiring in-the-money, which means they were far away from the stock price). Then, we recorded how many points the call and put strikes were from the stock price.

➜ Each subsequent day, we recorded the combined price of the call and put options that were the same distance away from the stock price as the initial call and put. This process was repeated until each respective expiration was reached.

Like the previous study, we tracked the “remaining extrinsic value” on each day, which is the combined price of the call and put relative to the initial price of the call and put. Finally, we averaged the remaining extrinsic across all of the occurrences based on the number of days until expiration.

OTM = Out-of-the-Money

Note: The non-existent decay at the beginning of the curve is due to the fact that the longest-duration option tested had around 80 days to expiration.

As you can see here, the decay curve is almost the opposite of the at-the-money decay curve in the previous example. In this case, the out-of-the-money theta decay slowed down in the final 30 days. More specifically, the decay from 50% to 25% took about 20 days, while the decay from 25% to 0% took about 30 days, on average.

From this specific dataset, the steepest decay for far out-of-the-money options occurred from 75 to 50 days to expiration.

Great job! You should now have a much deeper understanding of option theta, and the factors that contribute to the level of an option’s decay.

Option Theta FAQs

What is a good theta for options?

Since theta measures the rate at which an option decays, low theta is good for long options. High theta, on the other hand, is good for short options.

How do you profit from theta?

Theta measures the rate at which an option declines in value on a daily basis. Traders short options profit from their positive theta with every passing day, assuming stock price and implied volatility remain the same.

What does theta mean in options?

In options trading, the Greek theta tells us how much an option will decline in value with every passing day in a constant market. In a steady market, theta works in the favor short option sellers and against long option buyers.

Do options decay intraday?

Options decay every moment of every day. As long as the clock is ticking, options shed value. Theta even applies to days when the market is not open.

Additional Resources

Options Theta – The Greeks – CME Group

What is Option Delta? Ultimate Guide w/ Visuals

Posted on January 26, 2022February 10, 2022 by Chris Butler

Last updated on February 10th, 2022 , 07:11 pm

An option’s delta represents the directional risk component of an option position, or its exposure to changes in the underlying stock price.

Delta is the option Greek that measures an option’s directional exposure, as delta is used to estimate an option’s expected price change with $1 changes in the price of the stock.

To illustrate what this means, let’s look at a very basic example. In the following table, pay attention to how each option’s delta predicts the option’s price in each scenario:

The table above demonstrates the application of delta to assess an option’s expected price change:

➜ To estimate an option’s price after a $1 increase in the stock price, add the option delta to the option price.

➜ To estimate an option’s price after a $1 decrease in the stock price, subtract the option delta from the option price.

You’ve learned the basics of what an option’s delta represents! Now, let’s dive a bit deeper and discuss the differences between the deltas of calls and puts.

Call Option Deltas vs. Put Option Deltas

So, you know the basics of what delta represents, but now it’s time to learn about the differences between call and put deltas. As you may have noticed in the table from the last section, the call deltas are positive, and the put deltas are negative. More specifically:

➜ Call deltas are positive, ranging from 0 to +1

➜ Put deltas are negative, ranging from -1 to 0

In general, this means:

➜ When the stock price rises, call prices are expected to increase and put prices are expected to fall.

➜ When the stock price drops, call prices are expected to fall and put prices are expected to increase.

As a result, traders who buy call options or sell put options benefit from stock price increases. On the other hand, traders who sell call options or buy put options benefit from stock price decreases.

With that said, let’s visualize these concepts with some real data. First, we’ll analyze call option prices. Then, we’ll analyze put option prices.

Call Option Price vs. Stock Price Changes

As an illustration, we analyzed the price changes of a call option traded on SPY. Here are the specifics:

Stock: S&P 500 ETF (ticker symbol: SPY)

Time Period: January 29th, 2016 to March 18th, 2016

Option: March 195 Call

Let’s take a look! In particular, pay attention to the relationship between the price changes of SPY and the call option:

Call option price changes vs. Stock price changes

As shown here, there is a strong relationship between the price changes of the stock and the call option. A call’s positive delta expresses the direct correlation between the stock price and the call price.

Next, we’ll look at the same example, except we’ll swap out the call option with a put option.

Put Option Price vs. Stock Price Changes

In this example, we’ll visualize the price changes of the March 200 put on SPY.

In particular, note the correlation between the price changes of SPY and the put option.

Put option price changes vs. stock price changes

As illustrated here, the put option’s price is inversely related to changes in the price of SPY shares. A put option’s negative delta expresses the inverse correlation between the stock price and the put’s price.

Using Delta to Measure Directional Risk

Now, it’s time to learn about how an option’s delta value represents its price sensitivity relative to movements in the stock price.

As mentioned earlier:

➜ Call deltas are positive, ranging from 0.0 to +1.0

➜ Put deltas are negative, ranging from -1.0 to 0.0

Consider the following call option positions:

Now, let’s compare the sensitivity of these positions:

➜ The call option with a delta of +0.95 is expected to experience a price change of ±$0.95 with a $1 change in the stock price.

➜ The call option with a delta of +0.10 is expected to experience a price change of $0.10 with a $1 change in the stock price.

Consequently, a call option with a delta of +0.95 has almost ten times more directional risk than a call option with a delta of +0.10. The same concept applies to put options. As an illustration, let’s visualize the sensitivity of call and put options with various delta values.

Visualizing Call Option Price Sensitivity

First, let’s start with the setup for this example:

Stock: S&P 500 ETF (ticker symbol: SPY)

Time Period: September 27th, 2015 to August 20th, 2015

Expiration: August 21st, 2015

To visualize the price changes of SPY call options with different deltas, we analyzed three separate call options with deltas of +0.25, +0.50, and +0.75, respectively. When examining this visual, notice how each option’s delta translates to its degree of price sensitivity:

Call option delta: call price changes vs. stock price changes.

In the highlighted area, SPY experienced a $4 increase in its price. How did each call option’s price respond?

In the example above, the option’s delta was very accurate. However, it’s important to note that it won’t always work so perfectly, as all of the option Greeks are theoretical values that come from option pricing formulas. Nevertheless, the option Greeks tend to be fairly accurate.

Next, we’ll run through the same example, except this time we’ll be analyzing put options.

Visualizing Put Option Price Sensitivity

To analyze put option price sensitivity based on the option’s delta, we’ll use the same stock, time period, and expiration cycle as before. However, we’ll analyze three separate SPY put options with deltas of -0.25, -0.50, and -0.75, respectively.

Put option delta: put price changes vs. stock price changes.

In the highlighted area, SPY experienced a $4 increase in its stock price. How did each put option respond?

In the visual example, the put option with a delta of -0.50 had an actual price change of -$2.10 relative to a $4 increase in the stock price. A $2.10 price change was only $0.10 away from the projected price change based on the option’s delta. Very impressive!

In the last section, we’re going to quickly discuss one of the major factors that determine an option’s delta.

Option Strike Price vs. Delta

In this final section, we’re going to quickly discuss one of the major factors that determine an option’s delta: the strike price of the option relative to the stock price. Here’s a quick guide to in-the-money, at-the-money, and out-of-the-money options:

In-the-money: Call options with a strike price below the stock price; Put options with a strike price above the stock price.

At-the-money: A call or put option with a strike price equal to or near the stock price.

Out-of-the-money: Call options with a strike price above the stock price; Put options with a strike price below the stock price.

Most of the time, options in each of these categories have deltas in the following ranges:

The following visual serves as a visual representation of the table above:

At strike prices lower than the stock price, call deltas are closer to +1, and put deltas are closer to 0. At strike prices near the stock price ($207), option deltas are close to ±0.5. At strike prices above the stock price, call deltas are closer to 0 and put deltas are closer to -1.

As an options trader, you have full control over the strike price you trade.

When trading in-the-money options, you will have more profit/loss exposure when the stock price changes.

When trading out-of-the-money options, you will have less profit/loss exposure when the stock price changes.

Additional Resources

Options Delta – The Greeks – CME Group

What is Option Volume?

What is Open Interest?

Open Interest Example

The Importance of Option Liquidity

Which Options are the Most Liquid?

Option Liquidity vs. Time to Expiration

AAPL Volume and Open Interest

Next Lesson

Options Trading for Beginners

Long Call Options Explained

Long Put Options Explained

Additional Resources

"Bid and "Ask" Explained

Bid and Ask Spread: Market Makers

Bid and Ask Spread Example

Spread in Stocks vs. Options

Which Options Have the Widest Bid-Ask Spreads?

Bid-Ask Spreads of Long-Term Options (LEAPS)

Spreads vs. Market Volatility

What Is The Effective Spread?

Option Order Types

Bid-Ask Spread FAQs

Next Lesson

Leverage in Options Trading Explained

Intrinsic and Extrinsic Value in Options Trading Explained

11 Tips for Options Traders

Additional Resources

What are Intrinsic and Extrinsic Value?

Intrinsic and Extrinsic Value at Expiration

Intrinsic Value of Call Options

Call Option Example

Intrinsic vs. Extrinsic: Out-of-the-Money Call Option

Intrinsic Value of Put Options

Intrinsic vs. Extrinsic Value: In-the-Money Put

Intrinsic vs. Extrinsic Value: Out-of-the-Money Put

What Determines an Option's Extrinsic Value?

Option Value and DTE

Next Lesson

Implied Volatility Explained (The ULTIMATE Guide)

Option Greeks Explained: Delta, Gamma, Theta & Vega

Gamma Squeeze and Meme Stocks Explained

Additional Resources

Option Expiration

When Do Options Expire?

What's the Longest-Term Options Expiration Date?

How to Choose an Option Expiration Cycle

Consider Your Strategy

Consider Liquidity / Trading Activity

American vs European Option at Expiration

Final Word

Option Expiration FAQs

Next Lesson

Options Trading for Beginners: The ULTIMATE Guide

Implied Volatility Explained (The ULTIMATE Guide)

The Vertical Spread Options Strategies: Beginner Basics

Covered Calls for Beginners

Additional Resources

Stock Price at $120

Long Option Exercise

Short Option Assignment

Strike Price vs. Stock Price: ITM, ATM & OTM

Stock Price at $120

Call Option Strike Price vs. Premium

Put Option Strike Price vs. Premium

Final Word

Next Lesson

Options Trading for Beginners: The ULTIMATE Guide

Leverage in Options Explained

7 Covered Call ETFs

Additional Resources

Strike Prices & Expiration Dates

Standard Option Contract Multiplier

Call Option Basics

Call Option Trade Example

Put Option Basics

Put Option Trade Example

Leverage in Options Trading Explained

Option Greeks Explained: Delta, Gamma, Theta & Vega

11 Tips for Options Traders

Additional Resources

Basics of Calls and Puts

What is a Strike Price?

Options Expiration

Intrinsic & Extrinsic Value

Exercise & Assignment

The Bid-Ask Spread

Volume & Open Interest

Order Types: Market, Limit, GTC, Stop-Loss