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Category: Options Trading

What Are Options? The Basics of Call & Put Options

Posted on by Mike Martin

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

Calls vs Puts: Options Trading

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.

call option rights

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.

put option rights

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.

What Are Options? Put Visualization

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.

Back to Option Basics ➥

Additional Resources

What Are Options? – Forbes

Chris Butler portrait

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

Posted on by Chris Butler

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

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

Stocks vs Option

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

Long Call

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

Long Put Chart

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. 

Recommended Reading

Additional Resources

What are Option’s? – Forbes

Chris Butler portrait

Options Trading Basics | 9 Simplified Guides w/ Visuals

Posted on by Chris Butler

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

Learn the absolute essential options trading concepts!

Options Trading Explained

Options_Trading_Explained-compressor

What is options trading?

 
Read Guide

​Basics of Calls and Puts

Screenshot (9)

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

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
Chris Butler portrait

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

Posted on 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.

theta table options

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

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!

aapl theta decay

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!

 
tsla extrinsic value options

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:

theta moneyness

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!

 
nflx time decay options

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!

 
fb time decay options

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!

 
FB strangle intrinsic value

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

Option Value vs Time To Expiration theta

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

 
ATM option decay 1

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

 
OTM time decay

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.

Back To Greeks Home ➥

Option Theta FAQs

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. 

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. 

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. 

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

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What is Option Delta? Ultimate Guide w/ Visuals

Posted on 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:

option delta

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?

put option delta

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:

call and put delta

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

 

Option delta vs. strike price.

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.

Back To Greeks Home ➥

Additional Resources

Options Delta – The Greeks – CME Group

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Option Greeks | 5 Visual Guides to Measuring Risk

Posted on by Mike Martin

Last updated on February 9th, 2022 , 10:02 am

Greek Pillars

In the below guides, projectfinance will teach you everything there is to know about the Greeks in options trading!

Option Greeks 101

greeks 2

If you want to trade options, you must know the Greeks. The good news? They can be simplified. Delta · Gamma · Theta · Vega. 

Start Learning!

Option Risk #1: Delta

Delta estimates an option’s price change when the stock price rises or falls by $1. In other words, delta is used to gauge an option’s directional exposure.

Learn Delta!

Option Risk #2: Gamma

An option’s directional exposure changes when the stock price shifts. Gamma estimates how much an option’s delta will change when the stock price rises or falls by $1.

Learn Gamma!

Option Risk #3: Theta

The passage of time is the enemy of option buyers, and the best friend of option sellers. Theta estimates how much an option’s price will fall with each day that passes.

Learn Theta!

Option Risk #4: Vega

greeks

Implied volatility rises and falls with investor sentiment. Vega estimates an option’s price sensitivity relative to changes in implied volatility.

Learn Vega!

Additional Resources

Greeks (finance) – Wikipedia

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tastytrade Trading Platform Tutorial

Posted on by Chris Butler

Last updated on September 4th, 2024 , 12:55 pm

tasty logos

The tastyworks trading platform is what we use to trade stock, options and futures. tastyworks has changed the trading industry by introducing a revolutionary commission structure (close trades for free, $10 commission-cap per option leg, and more), and clean, intuitive trading software.

In this tastyworks tutorial, we’ll cover the basic features and look at how to navigate through the tastyworks platform. More specifically, you’ll learn:

✓ How to add symbols to a watchlist, and one powerful watchlist feature you should know.

✓ Using the ‘Recent Symbols’ tab to quickly check your frequently viewed stocks.

✓ How to search for various stocks using the search box.

✓ How to easily navigate through the trade page, and some awesome features on the trade page that make for a better trading experience.

Back to tastyworks Tutorials
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Volatility Skew in Options Trading (Guide w/ Visuals)

Posted on by Chris Butler

Last updated on March 11th, 2022 , 08:50 am

A stock’s implied volatility represents the overall level of a stock’s option prices. However, each individual option trades with its own implied volatility. By analyzing the prices (implied volatility) of options at various strike prices, we can learn if a particular stock trades with volatility skew, as well as other useful bits of information from that skew.

What is Volatility Skew?

Volatility skew refers to the inequality of the implied volatility of out-of-the-money calls and puts (you can look at in-the-money options, too, but in this post, we’ll keep things simple and focus on out-of-the-money options). For example, on most equities, the volatility skew lies with out-of-the-money puts. That is, the implied volatilities of out-of-the-money puts exceed the implied volatilities of out-of-the-money calls at similar distances from the current stock price.

Downside Volatility Skew

To illustrate downside volatility skew, let’s take a look at an example in the S&P 500 Index (SPX):

volatility skew 2

As we can see, the at-the-money put (2,310) is trading at a premium to the at-the-money call (2,310), and has an implied volatility 1.5% greater than the call. If we look at the put that’s 100 points lower than SPX, we see that the 2,210 put is trading for $7.75 (an implied volatility of 13.7%). On the other hand, if we look at the call that’s 100 points above SPX, we see that the 2,410 call is trading for $1.25 (an implied volatility of 8.2%).

So, since the out-of-the-money put is trading at a higher price (and therefore implied volatility) than the out-of-the-money call that’s the same distance away from SPX, we learn that SPX has downside volatility skew. 

What Causes Downside Volatility Skew?

In most equities, downside volatility skew is present. Why? Well, most people own stocks in their investment portfolios. There are two very simple and common ways to use options in a long stock portfolio:

1. Purchase out-of-the-money puts to hedge off the risk of a decrease in the stock price (a protective put)

2. Sell out-of-the-money calls to create a potential stream of income on shares of stock without adding any risk (a covered call position).

These two activities cause natural buying pressure in put options and selling pressure in call options, which results in more expensive puts and cheaper calls. Of course, not all of the skew comes from long stock investors, there are speculators as well. The bottom line is that in most equities, the risk is perceived to the downside, not the upside. So, you’ll typically observe downside volatility skew in equities.

Upside Volatility Skew

On the other side of the spectrum, we have upside volatility skew, where out-of-the-money call options are more expensive (higher implied volatility) than out-of-the-money puts.

Which products tend to have upside volatility skew? The most obvious products that come to mind are volatility-related underlyings, such as VIX options, VXX, and UVXY. Why? These products have the potential to explode when the stock market falls, which means purchasing call options in these products is similar to buying puts in equities.

As an example, let’s take a look at options in VXX (the Short-Term VIX Futures ETN), a product that attempts to track the performance of S&P 500 implied volatility:

volatility skew 4

In this case, we can see that the price and implied volatility of the out-of-the-money put (15) are far less than the price and implied volatility of the out-of-the-money call (22) that’s the same distance from the current price of VXX. As a result, the volatility skew in VXX is to the upside.

What Does Volatility Skew Tell You?

There are three useful pieces of information that one can glean from an underlying’s volatility skew:

1. The direction in which the risk is perceived to be in the underlying.

2. How implied volatility will change relative to movements in the underlying.

3. The prices of call spreads and put spreads on that underlying.

#1: An Underlying’s Perceived Risk

As discussed earlier, a downside volatility skew indicates that the market is pricing in more risk for decreases in the underlying than increases in the underlying. On the other hand, upside volatility skew indicates more risk being priced into increases in the underlying than decreases in the underlying.

#2: How Implied Volatility Will Change Relative to Underlying Movements

In stocks with downside volatility skew, the implied volatility of the underlying will typically increase if the stock price falls. As an example, let’s look at the relationship between the S&P 500 Index and the VIX Index:

Volatility Skew and Volatility Path: SPX Index vs. VIX Index

The VIX Index quantifies the prices (implied volatility) of near-term options on the S&P 500 Index (SPX). As shown earlier, SPX typically has downside volatility skew. In the chart above, we can see that when SPX falls, SPX implied volatility (the VIX) tends to increase.

What about on an underlying with upside volatility skew? To illustrate changes in implied volatility on an underlying with upside volatility skew, let’s examine the relationship between changes in the VIX Index and the implied volatility of VIX options (quantified by VVIX):

Volatility Skew and Volatility Path: VIX vs. VVIX

As we can see here, as the VIX Index increase, so do the implied volatilities of VIX options (VVIX).

So, volatility skew can tell you how the implied volatility of the underlying’s options are expected to change relative to changes in the underlying price.

Why does this matter? Well, if you’re trading positive delta, positive vega strategies on a product with upside volatility skew, you’ll know that an increase in the underlying should lead to profits from changes in direction and volatility.

On the other hand, if you’re trading negative delta, negative vega strategies on a product with downside volatility skew, and that underlying falls in price, you can expect some of your directional profits to be offset by an increase in volatility.

#3: The Prices of Call Spreads and Put Spreads

The third helpful piece of information that the skew of an underlying’s option volatility can tell you is the price of call and put spreads (in a broad sense):

➥In products with upside volatility skew, call spreads trade cheap and put spreads trade expensive.
 
➥In products with downside volatility skew, put spreads trade cheap and call spreads trade expensive.

Let’s take a look at some examples:

As we know, SPX volatility is skewed to the downside. If we were to buy the put spread in this example, we’d be buying a put with 10% IV and selling a put with 11.7% IV. The higher IV we’re selling helps reduce the cost of the spread price.

If we look at the call spread from the long side, we’re buying an 8.5% IV option and selling a 7.7% IV option. Since we’re selling an option with a lower IV than the option we’re buying, the spread’s price is more expensive.

In both cases, the spreads are $50 wide and the long options are at-the-money. However, the downside skew results in a cheaper put spread and a more expensive call spread. Consequently, put spread buyers and call spread sellers benefit, while put spread sellers and call spread buyers have less advantageous risk/reward setups.

Now, let’s look at the prices of spreads on an underlying with volatility skewed to the upside. In this example, we’ll use VXX:

In the case of these VXX spreads, we can see that the 18/16 put spread is trading for $0.87, while the 19/21 call spread is trading for $0.43. This can be explained by the fact that we’re buying a 55.4% IV put, while selling a 46.2% IV put, resulting in an expensive spread.

On the other hand, the call spread is much cheaper since we’re buying a 58.3% IV option and selling a 66.2% IV option. Now, while VXX is slightly closer to the put spread, we’d still see the same result if VXX were $18.50 (right in the middle of both spreads).

So, in underlyings with upside volatility skew, call spreads will trade cheaper and put spreads will trade more expensive, which is beneficial for call spread buyers and put spread sellers. In the case of call spread sellers and put spread buyers, the risk/reward will be less favorable.

Summary

Well, that wraps up the post on volatility and skew! I hope you’ve learned something that can help you in your trading.

To summarize what this post has covered, here are the key points to remember:

  • Individual options trade with their own levels of implied volatility based on their respective prices.
  • In products where out-of-the-money puts are more expensive than out-of-the-money calls, volatility is said to be skewed to the downside.
  • In products where out-of-the-money calls are more expensive than out-of-the-money puts, volatility is skewed to the upside.
  • An underlying’s volatility skew can provide you with three helpful pieces of information: 1. Where the risk is perceived to be 2. How implied volatility is likely to change relative to the underlying’s movements 3. Which spreads will be more expensive, and which will be cheaper.

Next Lesson

Additional Resources

What Does Implied Volatility Skew Measure? – Derivatives Journal

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Top 3 Options Trading Strategies for Beginners

Posted on by Chris Butler

Last updated on February 17th, 2022 , 05:58 am

With so many options trading strategies available, where might beginners want to start? In this post, we’ll cover our picks for the top 3 options trading strategies for beginners.

Strategy #1: Selling Put Spreads

Our first options strategy for beginners is selling put spreads (short put spreads), as the strategy has bullish market exposure (which most investors want), has limited loss potential, and can be implemented in small trading accounts.

Setting Up the Trade

Here’s how a short put spread is constructed:

1. Sell a put option.

2. Buy another put option at a lower strike price than the sold put (same quantity and expiration cycle).

The position will be entered for a credit, which means you’ll be collecting money from selling the spread. This is because the put you sell will be more expensive than the put you buy.

How the Trade Makes Money

In the simplest explanation, a short put spread makes money as long as the stock price remains above the strike price of the short put as time passes:

 

Options Trading Strategies for Beginners: Selling a put spread

As we can see, there’s a point in time where the stock price is below its price from the entry point of the short put spread. But, since time has passed, the put spread has lost value and is therefore profitable.

Short put spreads lose money when the stock price falls, but have limited loss potential. The maximum loss occurs when the stock price is below the purchased put’s strike price at expiration.

Watch me set up a real short put spread in Netflix (NFLX).

Strategy #2: Selling Iron Condors

Selling an iron condor (short iron condor) is a great options trading strategy for beginners because the position is non-directional, providing profit potential in range-bound stocks. The trade can be as conservative or aggressive as you’d like.

Setting Up the Trade

Here’s how to set up a short iron condor:

1. Sell a put spread (sell a put, buy another put at a lower strike price).

2. Sell a call spread (sell a call option, buy another call at a higher strike price).

The position will be entered for a credit, since the puts and calls you sell will be more expensive than the puts and calls you purchase.

How the Trade Makes Money

Short iron condor positions make money when the stock price remains between the strike prices of the call and put that are sold:

 

Options Trading Strategies for Beginners: Selling an iron condor

You’ll lose money when selling iron condors if the stock price moves too much in either direction. The maximum loss potential occurs when the stock price is above the purchased call option’s strike price or below the purchased put option’s strike price at expiration.

Watch me set up a real iron condor position in the Russell 2000 ETF (IWM).

 

Strategy #3: Covered Calls

Our third options strategy for beginners is the covered call, which is great strategy to start with because those with stock investments can easily implement the strategy.

Covered calls require the ownership of 100 shares of stock, so the strategy requires more money to get started, making it less accessible to those with small trading accounts. However, for those with at least 100 shares of stock in their investment portfolios, covered calls can provide downside protection if the stock price falls, and profit potential when the stock remains flat.

Setting Up the Trade

Covered calls are structured with the following positions:

1. Buy 100 shares of stock.

2. Sell 1 call option against the shares (typically expiring in 30-60 days).

How the Trade Makes Money

Covered call positions make money as long as the stock price doesn’t fall substantially:

 

Options Trading Strategies for Beginners: Covered Calls

As we can see, the covered call position outperforms the stock position over the entire period, as the premium received from selling the call option against shares provides downside protection when the shares fall. Additionally, when the share price remains flat or increases gradually over time, the covered call position will also outperform.

The only time a covered call position will underperform a long stock position is when the share price increases substantially.

Watch me set up a real covered call position in the Brazil ETF (EWZ).

Closing Thoughts

When starting out as an options trader, the number of strategies that can be used may be intimidating, especially the more complex strategies.

In my opinion, the simplest strategies are the most effective for options traders of all levels. The three strategies discussed in this post are my picks for the best options trading strategies for beginners to start with.

Lastly, please be sure to check out the complete strategy guides for the listed strategies to fully understand how each strategy works and the risks involved.

Thanks for reading!

Next Lesson

Additional Resources

4 Best Options Trading Strategies in 2022 • Benzinga

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3 Best Credit Spread for Income Options Strategies

Posted on by Chris Butler

Last updated on April 25th, 2022 , 09:04 am

Top 3 Option Credit Spreads

Credit Spread Definition: A credit spread is a derivative strategy that involves the simultaneous purchase and sale of options contracts of the same class (puts or calls) on the same underlying stock or ETF. In order to be a “credit” spread, the net position effect will be a credit. “Debit spreads” result in a net debit. 

Credit spreads are very common among traders who trade options for income, as credit spread option strategies can profit in more than one way. Additionally, credit spreads have limited loss potential, which means losing trades won’t break the bank if sized properly.

Credit spreads profit from time decay or theta. Over time, options tend to go down in value. Being a net seller of options helps to capitalize on this.  

In this post, we’ll cover our picks for the top 3 credit spread option strategies for generating income.

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

What is a Credit Spread?

Before getting to the strategies, let’s cover what a credit spread is.

A credit spread option strategy collects premium when the trade is entered. In other words, the options that are sold bring in more premium than what’s paid out for the options that are purchased.

For example, if we sell a put option for $3.00 and buy another put option at a different strike price for $2.00, we’ll be collecting $3.00 from the option we sold and paying out $2.00 for the option we bought.

The net result is that the trade is entered for a $1.00 “credit” since we’re collecting more premium than we’re paying out.

Let’s look at a real example of a put spread that is entered for a net credit:

put credit spread strike prices

In this example, if we sell the 142 put for $5.96 and buy the 135 put for $2.56, we collect a net credit of:

$5.96 Collected – $2.56 Paid = $3.40 Credit

The trade in this example is sometimes called a “put credit spread,” but is also referred to as a “short put spread” or “bull put spread.”

The Top 3 Credit Spread Option Strategies

Now that we’ve covered what a credit spread is, let’s get to the fun stuff!

Option Strategy #1: Put Credit Spread

The first options strategy on our list is the put credit spread, which is constructed by selling a put option and purchasing another put option at a lower strike price. This strategy is both market neutral and bullish. 

Both options for the put credit spread should use the same quantity and expiration cycle.

The following table summarizes the key characteristics of the put credit spread strategy:

options table

Consider the following trade example:

put strike

Here are the trade’s characteristics:

trade

As long as the stock price remains above $97.50 as time passes, the position will start to see profits from the decay of the options in the spread. If the stock price is above $97.50 at the expiration date, the position will be profitable. If the stock price is above $100 at expiration, the profit will be $250 per put credit spread.

The worst-case scenario is that the stock plummets through the put spread. If the stock price is below the long put strike at expiration, the put credit spread will realize the maximum loss.

Put Credit Spread Example Trade

Let’s take a look at a put credit spread example trade so you can see how the strategy performs as the stock price changes. In this example, the 700 put is sold and the 640 put is purchased for a net premium of $18.05.

As a result, the maximum profit potential is $1,805 and the maximum loss potential is $4,195. Let’s see how the trade performed over time:

put credit spread example

 

As we can see, the spread does well when the stock price rises or remains flat over time, and the spread loses money when the stock price falls quickly. In this case, the spread was maximally profitable at expiration, as both puts expired worthless.

So, the put credit spread is a great trade to use when you believe a stock will remain above a certain price, but you want limited loss potential if you’re wrong.

Option Strategy #2: Call Credit Spread

The second credit spread option strategy on our list is the call credit spread, which is constructed by selling a call option and purchasing another call option at a higher strike price.  This strategy is both market neutral and bearish. Both options use the same quantity and expiration cycle.

Here are the call credit spread’s trade characteristics:

options table 5

Let’s take a look at an example trade:

options table 7

Here are the characteristics of this particular call credit spread:

table 8

In this case, the call credit spread will be profitable as long as the underlying asset (stock price) remains below the breakeven price of $128 as time passes. If the stock price is below $128 at expiration, the spread will be profitable. If the stock price is below $125 (the short call’s strike price) at expiration, the spread will expire worthless and the spread seller will keep all of the premium.

If the stock price rises substantially and is above the long call strike at expiration, the call credit spread will realize the maximum loss potential.

Call Credit Spread Example Trade

Let’s look at a successful call credit spread trade so that you can see how the spread works in relation to changes in the stock price.

In this example, we’ll look at a call credit spread in which the 120 call is sold and the 125 call is purchased for a net credit of $1.93. In this case, the maximum profit potential is $193 and the maximum loss potential is $307:

selling a call spread

As we can see, the strategy starts losing money when the stock price increases after the spread is sold. However, as long as the stock price is below the breakeven price of the spread as time passes, the position will start to see profits from the decay of the options. 

As a result, the call credit spread is a great strategy to use when you believe a stock will remain below a certain price, but want limited loss potential if you’re wrong.

Like put credit spreads, call credit spreads are impacted negatively by rises in implied volatility.  

Option Strategy #3: The Iron Condor

The third and final credit spread option strategy we’ll discuss is the combination of the first two strategies!

The short iron condor option strategy consists of a call credit spread and a put credit spread. As a result, the position is directionally neutral, and profits when the stock price remains between the two spreads as time passes.

Here are the key characteristics of the iron condor strategy:

iron condor characteristics

Here’s an iron condor example trade:

iron condor 9

Based on the strikes, entry credit, and strike widths, here are the trade’s profit/loss characteristics:

iron condor 19

In this case, the 110 call is sold and the 90 put is sold. As a result, the trade’s maximum profit zone is between $90 and $110 at expiration. However, as long as the stock price remains between the breakeven prices of $87.36 and $112.64 as time passes, the spread will begin to see profits from the decay of the options.

The maximum loss potential is $236 per iron condor, which occurs when the stock price is beyond the long call strike price or long put strike price at expiration.

Iron Condor Example Trade

Let’s finish by looking at a successful iron condor trade so you can see how the strategy performs relative to changes in the stock price.

In this particular example, we’ll look at an iron condor comprised of a 216/209 put credit spread and a 230/234 call credit spread. The net credit in this case is $1.18.

Here’s how the trade performed:

iron condor chart

In the beginning of the period, the stock price starts to rise towards the short call strike price of $230, and the trade starts to lose money. However, the stock comes back down and trades between the short strikes as time passes, leading to steady profits for the iron condor seller.

Summary of Main Concepts

We’ve covered a lot of ground here, so here are the key points to remember from this post:

•Credit spread option strategies are strategies that collect more premium from the sold options than what’s paid out for any purchased options.

•Credit spreads are very common among traders who trade options for income, as credit spread strategies can profit in more than one way (making them high probability trades), and have limited loss potential.

•Put credit spreads profit when the stock price remains above the spread’s breakeven price as time passes, and lose money if the stock price falls quickly and significantly.

•Call credit spreads profit when the stock price remains below the short call strike price as time passes, and lose money when the stock price increases quickly and significantly.

•The short iron condor option strategy consists of a call credit spread and a put credit spread. As a result, the position is a neutral strategy that profits when the stock price remains between the two spreads, but loses money when the stock price moves substantially in either direction.

Note! Trading options (particularly short options) come with significant risks. In order to better understand the risks of standardized options, read this guide from the OCC.

Credit Spreads FAQs

Credit spreads profit when the spread narrows. Over time, options tend to decay in value. This decay in value helps credit spreads become profitable. 

On a credit spread, the maximum profit is limited to the credit received. 

An example of a call credit spread can be seen in AAPL. If a trader believes AAPL will stay below $160/share, that trader could sell a 165 call and buy a 170 call for a net credit of $1. If AAPL is trading under 165 at the time these options expire, that trader will realize a profit of $1, or $100. 

Next Lesson

Additional Resources

4 Keys To Placing Your First Credit Spread | tastytrade

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