Options Trading Archives

Option Gamma Explained: The Ultimate Guide w/ Visuals

Posted on January 20, 2022February 11, 2022 by Chris Butler

Last updated on February 11th, 2022 , 06:21 am

All option positions have four primary risk exposures:

1) Changes in the price of the stock (directional risk – delta)

2) Changes in the directional risk of a position (gamma risk)

3) The passing of time (sometimes called time decay or theta decay)

4) Changes in the implied volatility of the options (expressed by vega)

Gamma is the option Greek that relates to the second risk, as an option’s gamma is used to estimate the change in the option’s delta relative to $1 movements in the share price. In other words, gamma estimates the change in an option’s directional risk as the stock price changes.

To clarify, let’s look at an example.

Basic Option Gamma Example

As an illustration, let’s look at a basic example of gamma in action. In the following table, work your way from left to right. Specifically, note how each option’s gamma relates to the option’s new delta after $1 changes in the share price:

In this example, the bolded numbers represent a growth in the option’s directional exposure. Additionally, this table demonstrates how gamma can be applied:

1) To estimate an option’s new delta after a $1 increase in the share price, add the option’s gamma to its delta.

2) To estimate an option’s new delta after a $1 decrease in the share price, subtract the option’s gamma from its delta.

Recall that call deltas range from 0 to +1, and put deltas range from -1 to 0. This brings us to two key concepts:

1) When the share price increases, call deltas get closer to +1, and put deltas get closer to 0.

2) When the share price decreases, call deltas get closer to 0, and put deltas get closer to -1.

The image below visualizes these concepts:

Well done! You’ve learned the basics of what an option’s gamma represents. Now, let’s explore more important concepts related to gamma. First, you’ll see some examples of how gamma impacts call and put deltas. Second, you’ll learn which options tend to have the most gamma risk.

Gamma of Calls and Puts

To build on the previous section, we’re going to visualize option gamma by comparing call and put deltas to changes in the stock price. Let’s dive in!

To visualize the impact of both call and put gamma, we chose a call and put on AAPL with the same strike price and expiration. Here are the specifics:

Stock: Apple Inc. (ticker: AAPL)

Time Period: June 1st, 2015 to August 21st, 2015

Expiration: August 21st, 2015

Call and Put Strike Price: $120

In this visual, be sure to compare the changes in the call and put delta as the stock price changes. In the shaded region, the relationships are the clearest.

Option Gamma Example: Call and Put Deltas vs. Stock Price Changes

As illustrated here, call and put deltas move in the same direction as the stock price. At the beginning of the shaded region, both options were at-the-money and had deltas near ±0.50. As the share price moved higher, the call delta changed to +0.87, while the put delta changed to -0.13.

On the other hand, when the share price collapsed, the call delta fell to +0.25, and the put delta dropped to -0.75. The changes in each option’s delta can be attributed to gamma. To understand why, it helps to think about delta and gamma in terms of probabilities. Next, you’ll learn about how to think about gamma in a probabilistic perspective.

Option Gamma and Probabilities

You know that delta represents an option’s expected price change relative to stock price changes. In addition to that, delta is an estimation of the probability that an option expires in-the-money. Therefore, gamma represents the change in an option’s probability of expiring in-the-money with shifts in the stock price.

To conceptualize gamma as the change in an option’s probability of expiring in-the-money, consider the following scenarios:

With the stock price at $100, an option with a strike price of $100 has a probability of expiring in-the-money of approximately 50%, which means both the call and put will have deltas near ±0.50.

Now, if the stock price increases to $105, the call option with a strike price of $100 should have a much higher probability of expiring in-the-money because the stock price is $5 above the strike price. Conversely, the put option should have a lower probability of expiring in-the-money because the stock price must drop by more than $5 for the put to be in-the-money.

Gamma helps explains the change in each option’s probability of expiring in-the-money (delta) with changes in the stock price. In general, when the stock price increases:

➜ All call options have a higher probability of expiring in-the-money.

➜ All put options have a lower probability of expiring in-the-money.

Conversely, when the stock price decreases:

➜ All call options have a lower probability of expiring in-the-money.

➜ All put options have a higher probability of expiring in-the-money.

Hopefully, thinking about gamma in a probabilistic light makes it a little easier to comprehend!

In summary, when the price of a stock changes, the deltas of the options on that stock do as well. Gamma estimates how much each option’s delta will change.

Additionally, delta can be used as an approximation for the probability of an option expiring in-the-money. Therefore, gamma can be interpreted as the change in an option’s probability of expiring in-the-money.

Great job! At this point, you know lots of information about gamma as it relates to calls and puts. Now, it’s time to go a step further and learn which options have the most gamma exposure.

Which Options Have the Most Gamma Risk?

At this point, you understand how gamma impacts option deltas. However, not all options have the same amount of gamma exposure. In this section, you will learn which options tend to have the most exposure to gamma.

To demonstrate this, we’re going to analyze gamma in three different ways. First, we’re going to examine in-the-money, at-the-money, and out-of-the-money option gamma. Second, we’ll look at options with various lengths of time until expiration. Lastly, we’ll examine the gamma of in-the-money, at-the-money, and out-of-the-money options as expiration approaches.

Option Gamma and "Moneyness"

Regarding gamma risk, one of the two factors to consider about an option is whether its strike price is in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM). There are two primary reasons for this:

1) In-the-money and out-of-the-money options have the least amount of gamma exposure.

2) At-the-money options have the most gamma exposure.

To illustrate this, we’ll look at a snapshot of SPY options from early 2016. In particular, we looked at options with approximately 50 days until expiration. Let’s take a look:

Clearly, options that are in-the-money or out-of-the-money have less gamma exposure than at-the-money options. In this particular example, the at-the-money option gamma suggests that the option deltas will change by ±0.05 with a $1 change in the stock price.

On the other hand, the further the strikes are away from the stock price, the less the option’s gamma exposure. Lower gamma indicates a smaller change in the option’s delta relative to changes in the stock price. Why is this? Well, one explanation is that a $1 change in the stock price doesn’t significantly lower the chances of deep-in-the-money or out-of-the-money options expiring in-the-money.

Next, we’ll explore the gamma of options with different lengths of time until expiration.

Option Gamma vs. Time to Expiration

The second most important factor that influences an option’s gamma is the amount of time left until the option expires. To analyze this, we averaged the gamma of calls and puts at each strike in SPY. Additionally, we investigated options with 14, 42, 77, and 197 days until expiration. Let’s look at the results!

As illustrated here, at-the-money options with little time until expiration have the most gamma exposure. Conversely, in-the-money and out-of-the-money options with fewer days until expiration have less gamma exposure.

Why is this? Well, as discussed earlier, gamma can be thought of as the change in an option’s probability of expiring in-the-money. When the stock price moves up or down by $1, at-the-money options with little time until expiration will experience the greatest change in the probability of expiring in-the-money (delta), since there’s less time for the option to become in-the-money again.

In regards to in-the-money and out-of-the-money options, the same concept can be applied. With such little time to expiration, in-the-money and out-of-the-money option gamma is less significant because a $1 shift in the underlying price doesn’t have a large impact on the probability of an option expiring in-the-money (delta).

For example, consider a stock that’s trading for $200. If there’s one day left until expiration, a 210 call’s delta will be close to zero because it’s almost certain to expire out-of-the-money. Now, if the stock price rises to $201, the 210 call’s delta will still be close to zero because there’s not much time left for the stock to increase the additional $9+ required for the 210 call to be in-the-money.

Hopefully this helps you understand in-the-money, at-the-money, and out-of-the-money option gamma over various time frames. We’ll be discussing these concepts further in the next examples.

Next, we’ll take a look at a visual example of at-the-money option gamma expansion as expiration approaches.

At-the-Money Option Gamma Near Expiration

As expiration approaches, at-the-money option gamma should increase significantly because smaller changes in the stock price have a larger impact the option’s probability of expiring in-the-money. Let’s visualize what this looks like with real data! Here is the setup:

Stock: Netflix (ticker symbol: NFLX)

Time Period: November 16th to December 18th (2015)

Expiration / Time to Expiration: December 18th, 2015 / 32 Days to Expiration

Put Strike Price: $120

Let’s take a look at what happens to the option’s delta and gamma as expiration approaches:

Option Gamma Example: NFLX Put Delta vs. Stock Price Changes

Early on in the period, NFLX increased from $110 to $130, which resulted in the put’s delta changing from -0.70 to -.20. In the final days of the period, NFLX decreased from $124 to $117, which resulted in the put’s delta changing from -0.25 to -1.00.

Even more specifically, early on in the trade, a $20 increase in the stock price caused the option’s delta to change by 0.50. However, when the option was closer to expiration, a $7 decrease in the stock price caused a 0.75 change in the option’s delta. In other words, a move one-third of the size resulted in a 50% larger change in the option’s delta. More significant changes in an option’s delta with smaller shifts in the stock price demonstrates the power of at-the-money option gamma near expiration.

Next, we’ll analyze in-the-money and out-of-the-money option gamma over the same time period.

ITM & OTM Option Gamma Near Expiration

Using the same stock and time period as before, let’s visualize what happens to the delta and gamma of a deep in-the-money put as expiration approaches:

In-the-Money Option Gamma Example #2: NFLX Put Delta vs. Stock Price Changes

As illustrated here, the put gamma decreased in the last few days before expiration because the option was nearly $20 in-the-money with little time until expiration. As a result, $1 changes in NFLX shares wouldn’t significantly decrease the probability of the option expiring in-the-money.

What about out-of-the-money option gamma? To answer this, we’ll examine the NFLX 135 call over the same period as above. Let’s take a look:

As illustrated here, the out-of-the-money call experienced a decrease in delta and gamma into expiration because the call was nearly $20 away from being in-the-money. As a result, $1 changes in the share price weren’t enough to have an impact on the option’s probability of expiring in-the-money.

To conclude this section, let’s recap what you’ve learned.

First, and most importantly, not all options have equal exposure to gamma. In general, at-the-money options with little time until expiration have the most gamma risk. On the other hand, in-the-money and out-of-the-money option gamma tend to be smaller, especially when the options get closer to expiration.

Next Lesson

Additional Resources

Gamma Definition – Investopedia

Gamma Explained | The Options & Futures Guide

Delta Hedging Explained (Visual Guide w/ Examples)

Posted on January 20, 2022April 14, 2022 by Chris Butler

Last updated on April 14th, 2022 , 10:22 am

In options trading, delta hedging is a derivative-based trading strategy used to balance positive and negative delta so their net effect is zero. When a position is delta-neutral, it will not rise or fall in value when the value of the underlying asset stays within certain bounds.

For options traders, this means their position is protected in the short term from price movements in the underlying stock, ETF, or index. When executed correctly, a delta neutral position can help offset changes in volatility.

However, maintaining a delta neutral position is an ongoing battle, and the transaction costs from constantly rebalancing can easily reduce the temporary benefits this strategy gives.

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

What is Delta Hedging?

Consider the following option positions:

In each of these option contract positions, the position delta may be large or small depending on the trader who has the position. In each of these scenarios, there may come a time when the trader wants to reduce the directional exposure.

For bullish positions (positive delta), directional exposure can be reduced by adding negative delta strategies to the position.

For bearish positions (negative delta), directional exposure can be reduced by adding positive delta strategies to the position.

Here is a list of strategies that can accomplish either one of these hedging goals:

Basic Delta Hedging Example

To demonstrate how delta hedging can be accomplished, consider Position B from the previous table shown above:

Position B has a delta of -3,700, which is bearish because the position is expected to profit by $3,700 when the stock price drops by $1. Alternatively, the strategy is anticipated to lose $3,700 when the stock price increases by $1.

In order to reduce the directional exposure of this position, the trader will have to add positive delta strategies to the position.

Let’s say the trader wants to buy shares of stock to hedge the position with a delta of -3,700. If the trader wanted to decrease the directional risk in half, the trader would have to buy 1,850 shares of stock.

Why 1,850?

The trader needs to reduce their delta from -3,700 to -1,850 (a 50% reduction), which can be done by adding 1,850 deltas to the position. Each long share of stock has a delta of +1, so buying 1,850 shares will add 1,850 deltas to the position, therefore reducing the -3,700-delta position to a -1,850 delta position: -3,700 + 1,850 = -1,850.

With a new position delta of -1,850, the trader is expected to lose $1,850 if the stock price increases by $1, which is 50% less than the initial -$3,700 loss per $1 share increase. Here is how the hedge works:

Delta Hedging in Detail

So, as we can see here, the trader still has the full exposure from Position B. However, the long shares offset the P/L of Position B by 50%. Because of this, delta hedging reduces the risk of a position, but the reduction in risk comes at the cost of less potential reward.

At this point, you may be wondering why you wouldn’t always delta hedge a position. The answer is that hedging is expensive because it reduces your overall potential reward by the cost of the hedge. Additionally, constantly needing to hedge positions may be an indication that the initial trade size was too large.

In the next section, we’ll explore two real scenarios where a delta hedge might be implemented, as well as visualize the performance of the position with and without the hedge.

Visualized Delta Hedging Examples

To demonstrate how a delta hedge might work in practice, let’s take a look at two common scenarios where options or stock can be used to hedge the directional exposure of a position. First, we’ll look at a long stock position that is hedged with long puts.

Trade Example #1: Hedging Long Stock With Long Puts

In this first example, we’ll look at a scenario where a trader owns 500 shares of stock. Being long 500 shares of stock results in a position delta of +500. If the trader wanted to reduce this directional exposure, they would have to add a strategy with negative delta. In this example, the negative delta strategy we’ll use is buying puts.

Since the trader is long 500 shares of stock, we’ll purchase five -0.35 delta put options against the position. Here is how the position looks at the start of the period:

As we can see here, buying five -0.35 delta puts against 500 shares of stock reduces the delta exposure by 35%. Let’s take a look at the P/L of each of these positions when the stock price falls:

In the middle portion of this graph, the P/L of the long shares and the long puts are plotted separately. As you can see, when the stock price collapses, the long stock position loses money, but the long puts make money. In the lower portion of the graph, the combined P/L of the long stock and long puts is plotted.

The key takeaway from this chart is that the stock position by itself experiences a drawdown greater than $10,000. However, with the long puts implemented as a delta hedge, the combined position only experiences a $4,000 drawdown at the lowest point. By adding the negative delta strategy of buying puts to the positive delta strategy of buying stock, the directional exposure is less significant.

Let’s take a look at what happens to the actual deltas of each position as the stock price changes:

As we can see here, the position delta of owning 500 shares is always +500 because the delta of a share of stock is always +1. However, the delta of a put option will change as the stock price changes and time passes. As the stock price falls significantly below the put’s strike price of $205, the put’s delta gets closer to -1. Since this example tracks the delta of five puts, the most significant position delta of the puts is -500.

At option expiry, the 205 put’s delta was -1, resulting in a position delta of -500 for five long puts. Because of this, the delta of each position cancels out to zero. With a position delta near zero, the long stock and long put combination will experience very little P/L shifts when the stock price changes. When revisiting the first graph, you’ll notice that the P/L fluctuations in the last half of the period are insignificant when compared to the initial P/L changes.

Alright, so you’ve seen an example of how long puts can be used to delta hedge a long stock position. Next, we’ll look at buying calls against a short stock position.

Trade Example #2: Hedging Short Stock With Long Calls

In the final example, we’ll look at a scenario where a trader shorts 300 shares of stock sold at market price. Being short 300 shares of stock results in a position delta of -300. If the trader wanted to reduce this directional exposure, they would have to add a strategy with positive delta. In this example, the positive delta strategy we’ll use is buying calls.

Since the trader is short 300 shares of stock, we’ll purchase three +0.30 delta call options against the position. Here is how the position looks at the start of the period:

As we can see here, buying three +0.30 delta calls against -300 shares of stock reduces the delta exposure by nearly 33%. Let’s visualize the performance of these positions when the stock price rallies:

In the middle portion of this graph, the P/L of the short shares and the long calls are plotted separately. As you can see, when the stock price rises, the short stock position loses money, but the long calls make money. In the lower portion of the graph, the combined P/L of the short stock and long calls is plotted.

The key takeaway from this chart is that the short stock position by itself experiences a drawdown of nearly $30,000. However, with the long calls implemented as a delta hedge, the combined position only experiences a $15,000 drawdown at the lowest point. By adding the positive delta strategy of buying calls to the negative delta strategy of shorting stock, the directional exposure is less significant.

Let’s take a look at what happens to the actual deltas of each position as the stock price changes:

As we can see here, the position delta of shorting 300 shares is always -300 because the delta of a share of stock is always +1. However, the delta of a call option will change as the stock price changes and time passes. As the stock price rises, the call option’s delta gets closer to +1. Since this example tracks the delta of three calls, the most significant position delta of the calls is +300.

At the expiration date, the 535 call’s delta was +1, resulting in a position delta of +300 for three long calls. Because of this, the delta of each position cancels out to zero. With a position delta near zero, the short stock and long call combination will experience very little P/L shifts when the stock price changes.

If you revisit the first chart, you’ll notice that the P/L variations near the end of the period are much less significant than the beginning of the period. This can be explained by the long call position delta growing closer and closer to +300, resulting in a net position delta closer to 0.

Note! Curious how delta hedging is accomplished using the Black-Scholes model? Check out this article!

Delta Hedging FAQs

Is delta hedging profitable?

When executed properly, delta hedging can help traders offset short term market risk. This risk can be in the form of earnings, interest rate and economic data. Delta hedging works more on securing current profits (or preventing further losses) from swings in the price of the underlying stock or underlying security than being profitable in itself.

How do you hedge with delta?

Delta hedging helps traders offset risk in both stock and options by neutralizing directional exposure. Delta hedging is accomplished by either buying or selling shares of the underlying security to offset the market exposure of option positions.

What does delta mean in hedging?

Delta is the option Greek that represents the expected price move of an option based on a $1 move in the underlying security. Delta hedging involves trading shares of stock to offset the risk of trading options.

Next Lesson

Additional Resources

Delta Hedging Definition – Investopedia

What are common delta hedging strategies? – Investopedia

Long Iron Condor Explained – The Ultimate Guide w/ Visuals

Posted on January 20, 2022May 9, 2022 by Chris Butler

Last updated on May 9th, 2022 , 05:16 am

The long iron condor is an options strategy that consists of simultaneously buying an out-of-the-money call spread and put spread on a stock in the same expiration cycle.

Since the purchase of a call spread is a bullish strategy, and buying a put spread is a bearish strategy, a long iron condor isn’t technically a directional position.

However, even though a long iron condor isn’t directionally specific (bullish or bearish), the strategy requires movement in the stock price or an increase in implied volatility to profit.

The long iron condor strategy is very similar to the long strangle, except an iron condor has less risk due to using spreads as opposed to naked options.

TAKEAWAYS

A long iron condor consists of buying a put spread and a call spread at the same time.
Both of these spreads must be of the same width and expiration.
Long iron condor’s profit when the options bought rise in value.
Long iron condors are best suited for directional traders who expect either upside or downside moves.

Long Iron Condor Characteristics

Here are the strategy’s general characteristics:

➥Max Profit Potential: (Width of Wider Spread – Debit Paid) x 100

➥Max Loss Potential: Debit Paid x 100

➥Expiration Breakevens

1. Upper Breakeven = Long Call Strike Price + Debit Paid

2. Lower Breakeven = Long Put Strike Price – Debit Paid

To further examine these characteristics, let’s take a look at a basic example.

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

Long Iron Condor Profit/Loss Potential at Expiration

In the following example, we’ll construct a long iron condor from the following option chain:

In this case, we’ll buy the 450 put and the 550 call, and sell the 400 put and 600 call. Let’s also assume the stock price is trading for $500 when entering the position:

• Initial Stock Price: $500

• Short Strikes: $400 short put, $600 short call

• Long Strikes: $450 long put, $550 long call

• Credit Received From Short Options: $0.72 (400 put) + $1.94 (600 call) = $2.66

• Debit Paid for Long Options: $6.15 (450 put) + $7.89 (550 call) = $14.04

• Total Debit Paid: $14.04 Debit Paid – $2.66 Credit Received = $11.38

The following visual describes this position’s potential profits and losses at expiration.

Long Iron Condor at Expiration

As illustrated here, a long iron condor’s profit potential lies outside of the long strike of the trade, which means the stock price must increase or decrease for the position to be profitable at expiration. Regarding losses, a long iron condor realizes the maximum loss potential when the stock price does not trade beyond the long strikes by expiration.

Below explains the performance of this position based on various scenarios at expiration:

➥Stock Price Below the Short Put Strike ($400) -OR- Above the Short Call Strike ($600):

One of the spreads of the iron condor expires fully in-the-money. With spreads strikes that are $50 wide, the iron condor would be worth $50. With an initial purchase price of $11.38, the long iron condor trader realizes the maximum profit of $3,862: ($50 iron condor expiration value – $11.38 purchase price) x 100 = +$3,862.

➥Stock Price Between the Short Put Strike ($400) and the Lower Breakeven Price ($438.62):

The long 450 put expires with more intrinsic value than the initial $11.38 purchase price of the iron condor. As a result, the trader realizes profits.

➥Stock Price Between the Lower Breakeven Price ($438.62) and the Long Put Strike ($450):

The long 450 put expires with less value than the initial $11.38 iron condor purchase price. As a result, the position realizes a partial loss.

➥Stock Price Between the Long Put Strike ($450) and the Long Call Strike ($550):

All of the iron condor’s options expire worthless, resulting in the maximum loss of $1,138: ($0 iron condor expiration value – $11.38 purchase price) x 100 = -$1,138.

➥Stock Price Between the Long Call Strike ($550) and the Upper Breakeven Price ($561.38):

The long 550 call has intrinsic value, but not more than the initial $11.38 iron condor purchase price. Because of this, the position is not profitable.

➥Stock Price Between the Upper Breakeven Price ($561.38) and the Short Call Strike ($600):

The long 550 call expires worth more than $11.38, which is the initial purchase price of the iron condor. As a result, the position is profitable.

Nice job! You’ve learned the general characteristics of the long iron condor strategy. Now, let’s go through some visual trade examples to see how the strategy performs over time.

Long Iron Condor Trade Examples

In this section, we’re going to visualize the performance of long iron condors over time. Each example uses the prices of options that recently traded in the market. Note that we don’t specify the underlying, since the same concepts apply to iron condors on any stock. Additionally, each example demonstrates the performance of a single iron condor position. When trading more contracts, the profits and losses in each case will be magnified by the number of iron condors traded.

Trade Example #1: Partial Loss on an Iron Condor Purchase

In this first example, we’ll look at a scenario where a trader realizes a partial loss after buying an iron condor.

Here are the trade details:

• Initial Stock Price: $202.31

• Strikes and Expiration: Long 196 Put and 208 Call; Short 182 Put and 215 Call; All options expiring in 72 days

• Premium Paid for Long Options: $4.18 for the 196 put + $2.82 for the 208 call = $7.00 in premium paid

• Premium Collected for Short Options: $1.79 for the 182 put + $0.78 for the 215 call = $2.57 in premium collected

• Net Debit (Price Paid): $7.00 premium paid – $2.57 premium collected = $4.43 net debit

• Breakeven Prices: $191.57 and $212.43 ($196 – $4.43 and $208 + $4.43)

• Maximum Profit Potential (Upside): ($7-wide call spread – $4.43 debit) x 100 = $257

• Maximum Profit Potential (Downside): ($14-wide put spread – $4.43 debit) x 100 = $957

• Maximum Loss Potential: $4.43 net debit x 100 = $443

As mentioned earlier, the maximum profit potential of an iron condor depends on the wider spread. In this example, the long call spread is $7 wide, and the long put spread is $14 wide. Because of this, the maximum profit potential of this iron condor occurs when the stock price collapses through the long put spread. More specifically, this trade has $257 in profit potential on the upside and $957 in potential profits on the downside. Consequently, this long iron condor position has a slightly bearish bias.

Let’s see what happens!

Long Iron Condor #1 Trade Results

As we can see here, the iron condor suffers steady losses from time decay because the stock price is between the position’s breakevens as time passes. At expiration, the stock price is trading for $210.41, which means the long 208 call was worth $2.41. Meanwhile, all of the other options expire worthless, which means the final value of the iron condor at expiration is $2.41. With an initial purchase price of $4.43, the net loss on the position is $202: ($2.41 iron condor expiration value – $4.43 purchase price) x 100 = -$202.

Lastly, since the long 208 call is in-the-money at expiration, the trader would end up with +100 shares if the option was held through expiration. If the trader did not want a stock position, the 208 call would need to be sold before expiration.

Trade Example #2: Max Profit Iron Condor Purchase

In the following example, we’ll investigate a situation where the stock price rises continuosly and is above the iron condor’s long call spread at expiration.

Here are the trade details:

• Initial Stock Price: $121.45

• Strikes and Expiration: Long 119 Put and 124 Call; Short 115 Put and 128 Call; All options expiring in 46 days

• Premium Paid for Long Options: $1.25 for the 119 put + $1.05 for the 124 call = $2.30 in premium paid

• Premium Collected for Short Options: $0.39 for the 115 put + $0.38 for the 128 call = $0.77 in premium collected

• Net Debit (Price Paid): $2.30 premium paid – $0.77 premium collected = $1.53 net debit

• Breakeven Prices: $117.47 and $125.53 ($119 – $1.53 and $124 + $1.53)

• Maximum Profit Potential: ($4-wide spreads – $1.53 net debit) x 100 = $247

• Maximum Loss Potential: $1.53 net debit x 100 = $153

In this example, both the long call spread and long put spread are $4 wide, so the profit potential is equal on both sides of the trade.

Let’s take a look at the position’s performance:

Long Iron Condor #2 Trade Results

In this example, we can see that the iron condor performs very well because the stock price surges through the long call spread. At expiration, the 124/128 long call spread is entirely in-the-money, while the 119/115 put spread expires worthless. However, since the 124/128 call spread is worth $4 and the iron condor was purchased for $1.53, the trader realizes the maximum profit of $247: ($4 iron condor expiration value – $1.53 initial purchase price) x 100 = +$247.

Since the entire long call spread is in-the-money at expiration, the exercise and assignments would offset, resulting in no stock position for the trader. However, it’s always possibile for the trader to be assigned early on the short 128 call when it’s in-the-money before expiration.

Trade Example #3: Long Iron Condor Gone Wrong!

In the final example, we’ll look at a situation where a long iron condor expires worthless, resulting in the maximum loss potential for the trader who purchased the spread.

Here are the trade details:

• Stock Price: $574.81

• Strikes and Expiration: Long 535 Put and 615 Call; Short 505 Put and 645 Call; All options expiring in 46 days

• Premium Paid for Long Options: $11.75 for the 535 put + $10.40 for the 615 call = $22.15 in premium paid

• Premium Collected for Short Options: $6.03 for the 505 put + $4.47 for the 645 call = $10.50 in premium collected

• Net Debit (Price Paid): $22.15 premium paid – $10.50 premium collected = $11.65 net debit

• Breakeven Prices: $523.35 and $626.65 ($535 – $11.65 and $615 + $11.65)

• Maximum Profit Potential: ($30-wide spreads – $11.65 net credit) x 100 = $1,835

• Maximum Loss Potential: $11.65 net debit x 100 = $1,165

Let’s see how this trade performed:

Long Iron Condor #3 Trade Results

In this final example, we can see that the initial drop in the stock price leads to healthy profits for the long iron condor trader. However, the stock price rebounds back and is between the long strikes at expiration, in which case the iron condor expires worthless. With an initial purchase price of $11.65, the loss at expiration is $1,165: ($0 iron condor expiration value – $11.65 initial purchase price) x 100 = -$1,165

Long Iron Condor: Pros and Cons

Final Word

Congratulations! You now know how buying an iron condor works as a trading strategy. Be sure to recap the main concepts of this guide below.

An iron condor consists of buying both a put spread and a call spread simultaneously.
Both of these spreads must be of the same width and expiration.
The max loss for iron condors is always the debit paid.
Max gain for long iron condors is: (Width of Wider Spread – Debit Paid)

Long Iron Condor FAQs

Is the iron condor always profitable?

In order for a long iron condor to be profitable, either the long call or long put purchased must rise in value. For call breakeven, the stock must rise to long call strike + debit paid. For put breakeven, the stock must fall to long put strike – debit paid.

When should I take profit on iron condor?

For long iron condors that are in-the-money, profit should be taken before expiration to avoid being assigned on the short option and possibly exercised on the long option. It is best to have a pre-established profit taking price in place before placing iron condor trades.

How often are iron condors profitable?

The profitability of iron condors will depend upon the “moneyness” structure of the options traded, implied volatility and the price of the underlying security.

The further an iron condor is sold out-of-the-money, the greater its possibly of success will be.

Next Lesson

Additional Resources

Long Condor – Options Industry Council

Iron condor – Wikipedia

Bull Call Spread Explained – The Ultimate Guide w/ Visuals

Posted on January 17, 2022March 24, 2022 by Mike Martin

Last updated on March 24th, 2022 , 07:13 am

A bull call spread is an options strategy that consists of buying a call option while also selling a call option at a higher strike price.

Both options must be in the same expiration cycle. Buying call spreads is similar to buying calls outright, but less risky due to the premium collected from the sale of a call option at a higher strike. As the name suggests, a bull call spread is a bullish strategy, as it profits when the underlying stock price rises.

We’re going to cover all of this in great detail, so be sure to keep reading if you want to master this strategy!

Let’s go over the strategy’s general characteristics:

TAKEAWAYS

The bull call spread consists of: 1. buying a call at strike price A 2. Selling a call at strike price B.
Max profit in a bull call spread is the difference between strike A and strike B minus the net premium paid.
In bull call spreads, max loss is the total premium paid.
The Breakeven for bull call spreads is strike A plus net debit paid.
The bull call spread is a cheaper way to go long when compared to straight call buying.

Bull Call Spread Strategy Characteristics

➦Max Profit Potential: (Call Spread Width – Net Debit Paid) x 100

➦Max Loss Potential: Net Debit Paid x 100

➦Expiration Breakeven: Long Call Strike + Net Debit Paid

➦Position After Expiration:

If the long and short call are both in-the-money at expiration, the assignments offset, resulting in no stock position. If only the long call is in-the-money at expiration, the resulting position is +100 shares of stock per call contract.

➦Assignment Risk:

When the short call of a bull call spread is in-the-money, a bull call spread trader is at risk of being assigned -100 shares of stock per short call contract. The probability of being assigned on short calls is higher when the short call has little extrinsic value. Alternatively, short call assignments are common before a stock’s ex-dividend date, primarily when the dividend is greater than the short call’s extrinsic value.

To gain a better understanding of these concepts, let’s walk through a basic example.

Bull Call Spread Profit/Loss Potential at Expiration

In the following example, we’ll construct a bull call spread from the following option chain:

In this case, let’s assume the stock price is trading for $150 at the time of entering the spread. To construct a bull call spread, we’ll have to buy a call option and sell the same number of calls at a higher strike price. In this example, we’ll buy one of the 145 calls and sell one of the 155 calls.

Initial Stock Price: $150

Long Call Strike: $145

Short Call Strike: $155

Premium Paid for the 145 Call: $8.80

Premium Collected for the 155 Call: $3.99

In this example, buying the 145 call for $8.80 and selling the 155 call for $3.99 results in a net debit of $4.81 (since $8.80 is paid, and $3.99 is collected). Additionally, the “spread width” is the difference between the long and short call strike, which is $10 in this case. Based on a net debit of $4.81 on a $10-wide bull call spread, here are the position’s characteristics:

Max Profit Potential: ($10-wide call strikes – $4.81 net debit paid) x 100 = $519

Max Loss Potential: $4.81 net debit paid x 100 = $481

Expiration Breakeven: $145 long call strike price + $4.81 debit paid = $149.81

Probability of Profit

This bull call spread example has a probability of profit slightly greater than 50% because the breakeven price ($149.81) is less than the current stock price ($150), which means the stock price can fall slightly and the position can still profit.

Position After Expiration

If the stock price is above 155 at expiration, both calls expire in-the-money. At expiration, an in-the-money long call expires to +100 shares, and an in-the-money short call expires to -100 shares, which results in no stock position for the call spread buyer.

If the stock price is between 145 and 155 at expiration, only the long call expires in-the-money, resulting in a position of +100 shares for the call spread buyer.

The following visual demonstrates the potential profits and losses for this bull call spread at expiration:

If the stock price is at or below the long call’s strike price of $145 at expiration, both the 145 and 155 call options will expire worthless, resulting in the maximum loss of $481.

If the stock price is in-between the strike prices at expiration, such as $149.81, the long 145 call will have value while the 155 call will expire worthless. At $149.81, the 145 call will be worth $4.81 ($149.81 Stock Price – $145 Strike Price) and the 155 call will be worth $0, resulting in no profit or loss on the trade.

If the stock price is above the short call’s strike price of $155, the entire 145/155 call spread will be worth $10 (the width between the strike prices), which means the profit on each call spread will be +$519.

Bull Call Spread Trade Examples

The first example we’ll investigate is a situation where a trader purchases an at-the-money call spread. An at-the-money bull call spread consists of buying an in-the-money call and selling an out-of-the-money call. When constructed properly, the breakeven price is slightly below the current stock price. Here’s the setup:

Initial Stock Price: $109.82

Strikes and Expiration: Long 100 call expiring in 45 days. Short 115 call expiring in 45 days

Net Debit Paid: $11.18 paid for the 100 call – $1.94 received for the 115 call = $9.24

Breakeven Stock Price: 100 long call strike price + $9.24 net debit paid = $109.24

Maximum Profit Potential: ($15-wide call strikes – $9.24 debit paid) x 100 = $576

Maximum Loss Potential: $9.24 net debit paid x 100 = $924

Let’s see what happens!

Bull Call #1 Results

In this example, the bull call spread position had both profits and losses at some point. With 14 days left until expiration, the call spread was worth slightly less than its maximum value of $15.

However, at expiration, the stock price was only slightly above the long call spread’s breakeven price. As a result, the long call spread trader didn’t make or lose any money by holding the trade to expiration.

However, the trade would have been profitable if the trader sold the spread when it was worth more than the entry price of $9.24. To close a bull call spread before expiration, the trader can simultaneously sell the long call and buy the short call at their current prices. As an example, if the trader closed the spread when it was worth $12, they would have realized $276 in profits: ($12 closing price – $9.24 purchase price) x 100 = +$276.

Since the long call is in-the-money at expiration, the trader would end up with +100 shares of stock (per contract) if they did not sell the long call before expiration. Upon selling the long call portion of a bull call spread, it’s wise to buy back the short call. Otherwise, the trader will expose themselves to unlimited loss potential.

Next, we’ll look at an example of a long call spread trade where the stock price moves against the position.

Unprofitable Call Spread Example

In this example, we’ll look at a situation where a trader buys an out-of-the-money long call spread. An out-of-the-money long call spread is constructed by purchasing an out-of-the-money call while also selling an out-of-the-money call at a higher strike price.

It’s important to note that purchasing out-of-the-money call spreads is a low probability trade because the breakeven price is above the stock price at entry. Additionally, the profit potential is greater than the loss potential.

Here’s the setup:

Initial Stock Price: $569.92

Strikes and Expiration: Long 575 call expiring in 35 days Short 635 call expiring in 35 days

Net Debit Paid: $32.45 paid for the 575 call – $11.00 received for the 635 call = $21.45

Breakeven Stock Price: $575 long call strike price + $21.45 debit paid = $596.45

Maximum Profit Potential: ($60-wide call strikes – $21.45 debit paid) x 100 = $3,855

Maximum Loss Potential: $21.45 debit paid x 100 = $2,145

As you can see, the long call spread’s breakeven price is more than $25 higher than the stock price when entering the trade, which means the stock price must increase more than $25 for the position to breakeven at expiration.

Let’s take a look at what happens:

Bull Call #2 Results

This example demonstrates that a significant stock price increase results in healthy profits for a bull call spread trader. Unfortunately, the stock price ends up dropping just as quickly. With the stock $45 points below the long 575 call at expiration, the long call spread expires worthless. The resulting loss for the call spread buyer is $2,145 ($21.45 debit paid x 100).

As mentioned before, a spread can always be closed before expiration if a trader wishes to lock in profits or losses. For example, if the trader in this example wanted to cut their losses when the spread traded down to $15, they would lock in $645 in losses: ($15 sale price – $21.45 purchase price) x 100 = -$645.

Alright, you’ve seen long call spread examples that break even and realize the maximum loss. In the final example, we’ll investigate a long call spread trade that winds up with its maximum profit potential.

Profitable Call Spread Example

In the final example, we’ll examine a long call spread example that ends up with its maximum profit potential.

Here are the specifics of the final example:

Initial Stock Price: $57.47

Strikes and Expiration: Long 49 call expiring in 82 days. Short 70 call expiring in 82 days.

Net Debit Paid: $11.10 paid for the 49 call – $1.85 received for the 70 call = $9.25

Breakeven Stock Price: $49 long call strike + $9.25 debit paid = $58.25

Maximum Profit Potential: ($21-wide call strikes – $9.25 debit paid) x 100 = $1,175

Maximum Loss Potential: $9.25 net debit paid x 100 = $925

Let’s see what happens!

Bull Call #3 Results

In the first 30 days of the trade, the stock price stagnates around the breakeven price of the long call spread. However, with around 45 days to expiration, the stock jumps 30% to $80 after an earnings announcement.

With the stock price $10 above the short call strike, the long call spread is worth around $20. With $21-wide strikes, the spread’s maximum value is $21. So, even though the position has around 45 days to expiration, the long call spread is worth near its maximum potential value.

When the call spread is worth $20, it’s likely that the long call spread trader closes the position for a profit because there’s only $1 left to make and $20 to lose.

If the trader did sell the spread for $20, the realized profit would be $1,075: ($20 sale price – $9.25 purchase price) x 100 = +$1,075.

Finally, if the spread was held through expiration, no stock position would be taken on because the exercise/assignment of the long and short call options cancel each other out. However, it’s possible that the spread trader is assigned on the short call when it’s deep-in-the-money before expiration.

Final Word

Congratulations! You now know how the bull call spread works as an options trading strategy. In summation, here is what we learned:

In a bull call spread, risk is limited to the net debit paid.
Bull call spreads can allow for less risk than just buying straight calls.
In the bull call spread, both upside and downside are capped.

* Want to make a little extra income from your bull call spread? Read our article on the bull call ladder strategy here! But be careful, this strategy introduces traders to great loss potential!

Additional Resources

What Is A Bull Call Spread? – Fidelity Investments

Bull Call Spread Definition – Investopedia

Bull Call Spread Debit … – The Options Industry Council (OIC)

Next Lesson

Option Exercise and Assignment Explained w/ Visuals

Posted on January 14, 2022February 11, 2022 by Mike Martin

Last updated on February 11th, 2022 , 06:38 am

Buyers of options have the right to exercise their option at or before the option’s expiration. When an option is exercised, the option holder will buy (for exercised calls) or sell (for exercised puts) 100 shares of stock per contract at the option’s strike price.

Conversely, when an option is exercised, a trader who is short the option will be assigned 100 long (for short puts) or short (for short calls) shares per contract.

TAKEAWAYS

Long American style options can exercise their contract at any time.
Long calls transfer to +100 shares of stock
Long puts transfer to -100 shares of stock
Short calls are assigned -100 shares of stock.
Short puts are assigned +100 shares of stock.
Options are typically only exercised and thus assigned when extrinsic value is very low.
Approximately only 7% of options are exercised.

The following sequences summarize exercise and assignment for calls and puts (assuming one option contract):

Call Buyer Exercises Option ➜ Purchases 100 shares at the call’s strike price.

Call Seller Assigned ➜ Sells/shorts 100 shares at the call’s strike price.

Put Buyer Exercises Option ➜ Sells/shorts 100 shares at the put’s strike price.

Put Seller Assigned ➜ Purchases 100 shares at the put’s strike price.

Let’s look at some specific examples to drill down on this concept.

Exercise and Assignment Examples

In the following table, we’ll examine how various options convert to stock positions for the option buyer and seller:

As you can see, exercise and assignment is pretty straightforward: when an option buyer exercises their option, they purchase (calls) or sell (puts) 100 shares of stock at the strike price. A trader who is short the assigned option is obligated to fulfill the opposite position as the option exerciser.

Automatic Exercise at Expiration

Another important thing to know about exercise and assignment is that standard in-the-money equity options are automatically exercised at expiration. So, traders may end up with stock positions by letting their options expire in-the-money.

An in-the-money option is defined as any option with at least $0.01 of intrinsic value at expiration. For example, a standard equity call option with a strike price of 100 would be automatically exercised into 100 shares of stock if the stock price is at $100.01 or higher at expiration.

What if You Don't Have Enough Available Capital?

Even if you don’t have enough capital in your account, you can still be assigned or automatically exercised into a stock position. For example, if you only have $10,000 in your account but you let one 500 call expire in-the-money, you’ll be long 100 shares of a $500 stock, which is a $50,000 position. Clearly, the $10,000 in your account isn’t enough to buy $50,000 worth of stock, even on 4:1 margin.

If you find yourself in a situation like this, your brokerage firm will come knocking almost instantaneously. In fact, your brokerage firm will close the position for you if you don’t close the position quickly enough.

Why Options are Rarely Exercised

At this point, you understand the basics of exercise and assignment. Now, let’s dive a little deeper and discuss what an option buyer forfeits when they exercise their option.

When an option is exercised, the option is converted into long or short shares of stock. However, it’s important to note that the option buyer will lose the extrinsic value of the option when they exercise the option. Because of this, options with lots of extrinsic value remaining are unlikely to be exercised. Conversely, options consisting of all intrinsic value and very little extrinsic value are more likely to be exercised.

The following table demonstrates the losses from exercising an option with various amounts of extrinsic value:

As we can see here, exercising options with lots of extrinsic value is not favorable.

Why? Consider the 95 call trading for $7. Exercising the call would result in an effective purchase price of $102 because shares are bought at $95, but $7 was paid for the right to buy shares at $95.

With an effective purchase price of $102 and the stock trading for $100, exercising the option results in a loss of $2 per share, or $200 on 100 shares.

Even if the 95 call was previously purchased for less than $7, exercising an option with $2 of extrinsic value will always result in a P/L that’s $200 lower (per contract) than the current P/L. F

or example, if the trader initially purchased the 95 call for $2, their P/L with the option at $7 would be $500 per contract. However, if the trader decided to exercise the 95 call with $2 of extrinsic value, their P/L would drop to +$300 because they just gave up $200 by exercising.

7% Of Options Are Exercised

Because of the fact that traders give up money by exercising an option with extrinsic value, most options are not exercised. In fact, according to the Options Clearing Corporation, only 7% of options were exercised in 2017. Of course, this may not factor in all brokerage firms and customer accounts, but it still demonstrates a low exercise rate from a large sample size of trading accounts.

So, in almost all cases, it’s more beneficial to sell the long option and buy or sell shares instead of exercising. We like to call this approach a “synthetic exercise.”

Congrats! You’ve learned the basics of exercise and assignment. If you’d like to know how the exercise and assignment process actually works, continue to the next section!

Who Gets Assigned When an Option is Exercised?

With thousands of traders long and short options in the market, who actually gets assigned when one of the traders exercises their option?

In this section, we’ll run through the exercise and assignment process for options so you know how the assignment decision occurs.

If a trader is short a single option, how do they get assigned if one of a thousand other traders exercises that option?

The short answer is that the process is random. For example, if there are 5,000 traders who are long a call option and 5,000 traders who are short that call option, an account with the short option will be randomly assigned the exercise notice. The random process ensures that the option assignment system is fair

Visualizing Assignment and Exercise

The following visual describes the general process of exercise and assignment:

If you’d like, you can read the OCC’s detailed assignment procedure here (warning: it’s intense!).

Now you know how the assignment procedure works. In the final section, we’ll discuss how to quickly gauge the likelihood of early assignment on short options.

Assessing Early Option Assignment Risk

The final piece of understanding exercise and assignment is gauging the risk of early assignment on a short option.

As mentioned early, only 7% of options were exercised in 2017 (according to the OCC). So, being assigned on short options is rare, but it does happen. While a specific probability of getting assigned early can’t be determined, there are scenarios in which assignment is more or less likely.

The following scenarios summarize broad generalizations of early assignment probabilities in various scenarios:

In regards to the dividend scenario, early assignment on in-the-money short calls with less extrinsic value than the dividend is more likely because the dividend payment covers the loss from the extrinsic value when exercising the option.

Final Word

All in all, the risk of being assigned early on a short option is typically very low for the reasons discussed in this guide. However, it’s likely that you will be assigned on a short option at some point while trading options (unless you don’t sell options!), but at least now you’ll be prepared!

Next Lesson

Additional Resources

Exercise and Assignment – CME Group

Learn About Exercise and Assignment – CME Group

Index Options vs Equity Options vs ETF Options w/ Visuals

Posted on January 13, 2022February 11, 2022 by Mike Martin

Last updated on February 11th, 2022 , 06:50 am

Options can fall into one of three categories: index options, ETF options, and equity options.

There are a lot of similarities, as well as a lot of important differences between the three types of options.

When compared to the other two option types, index options have the most contrast.

Let’s take a look at a table comparing the three, then jump right into the details!

TAKEAWAYS

Index options do not allow for “early exercise” and are settled in cash.
Indices do not offer stock.
ETF and equity options can be exercised at any time, at which point delivery of the underlying takes place.
Index options have tax advantages; ETF and equity options have no tax advantages.
When compared to index options, ETF options have tighter spreads.
When compared to ETF options, equity options have higher premiums.

	INDEX OPTIONS	ETF OPTIONS	EQUITY OPTIONS
Exercise Style:	European	American	American
Settlement:	Cash-Settled	Physical Delivery	Physical Delivery
Tax Advantages:	Has Tax Advantages (60/40)	No Tax Advantages	No Tax Advantages
Dividends:	No Dividends	Dividends	Dividends

Market Index Explained

Index Option Definition: An index option is a financial contract that gives the owner the right, but not the obligation, to buy or sell the value of an underlying index at the specified strike price at expiration.

This article assumes the reader has a basic understanding of call and put options. If you’re brand new to options trading, please check out our comprehensive article entitled “Options Trading for Beginners.”

In the stock market, an “index” measures the price performance of a basket of securities. The most popular indices are those that track major US market sectors, such as the S&P 500 (SPX), the Nasdaq (NDX), and the Dow Jones Industrial Industrial Average (DJX).

However, the breath of indices extends way beyond these products. As stated by sec.gov, there are indices for “almost every conceivable sector of the economy and stock market.”

There are, in fact, thousands of indices in the US alone, covering sub-sectors such as:

National Indices
Growth Indices
Value Indices
Sector Indices

Index Options Explained

Many indices offer options trading. These are the favorite types of options amongst professional traders. Let’s take a look at a few characteristics to understand why.

1. Index Options Are “European Style”

European style option can only be exercised (and thus assigned) at expiration. All index options are styled in the European fashion.

This is a great benefit for traders’ short options. American style options (like equity and ETF options) can be exercised at any time. When extrinsic value is low, and expiration approaches, assignment is a constant worry for short option holders.

This risk is eradicated with index options.

2. Index Options Are Cash Settled

Though many indices offer options, no index allows for the direct trading of its product.

If you are long an American style option, you have the right to convert that option to stock at any time. But since we just learned there is no trading stock on indices, what are long options converted to for these option types?

Index options are converted to cash upon exercise/assignment.

If at expiration, an index option is in-the-money, a transfer of cash between the long and short parties takes place by this “moneyness” amount to finalize the contract.

EXAMPLE:

SPX Value: 4,700
SPX Call: 4,695

For the above example, the short party would have to provide a cash payment of $500 to the long party at expiration.

Index options eliminate assignment issues related to “pin risk”. Investors who trade index options do not need to worry about waking up the next day to discover several hundreds of shares in their account.

3. Index Options Have Tax Advantages

According to section 1256 from IRS.gov, gains on index options are treated at 60% long-term capital gains and 40% short-term.

This is different from equity and ETF options, of which the short-term gains of both are taxed at the short-term rate. This rate is almost always higher than long-term rates.

Image from CBOE.COM

4. Index Options Pay No Dividends

Since index options have no underlying, no dividends are paid.

This eliminates the “dividend risk” that both ETF and equity call options experience leading up to the ex-dividend date

Exchange-Traded Fund (ETF) Explained

Exchange-Traded Fund Definition: ETFs are underlying issuing securities that track an index, sector, commodity, or other assets.

ETFs have a lot in common with indices, with one important exception: ETFs issue shares.

This share issuance makes things a bit more complicated when compared to index options.

Two of the more popular ETFs are SPDR S&P 500 ETF (SPY) and Invesco’s Nasdaq-100 Index (QQQ).

We remarked earlier that 2 index options also track these same benchmarks. So, what’s the difference?

ETF Options Explained

1. ETF Options Are “American Style”

American style option can be exercised (and thus assigned) at any time. All ETF options are styled in American fashion.

This may be advantageous to long options, but short options face the constant threat of being assigned. Though in reality this rarely happens, assignment is always in the back of the mind of option sellers.

2. ETF Options are Settled via Physical Delivery

Unlike index options, which are settled via a simple transfer of cash, ETF options demand physical delivery of the underlying.

1 Long Call Exercised to 100 Long Shares of Stock
1 Long Put Exercised to 100 Short Shares of Stock
1 Short Call Assigned to 100 Short Shares of Stock
1 Short Put Assigned to 100 Long Shares of Stock

Perhaps the greatest risk here is pin risk. If QQQ is trading at $389.92/share in the final moments of trading on expiration day, and you are short the $390 call, who’s to say that QQQ won’t rally in the last seconds of trading, forcing you to deliver a very expensive 100 short shares of stock?

Additionally, short American style options can in theory be assigned at any time.

3. ETF Options Have No Tax Advantages

Unlike index options, ETF options offer no preferential tax treatment – short-term gains are taxed 100% at your short-term tax rate.

4. ETF Options Pay Dividends

Most ETFs pay dividends.

While this isn’t usually a problem for put options, the value of some call options are adjusted to reflect this dividend. Since options pay no dividends, it is sometimes wise for a long call to exercise their contract to capitalize from this payment. Assignment risk is therefore present for short call options with low extrinsic value.

ETF Options Advantage Over Index Options

So now that we have slammed ETF options, perhaps we should say something nice about them.

1. ETF Options Offer Tighter Strike Prices than Index Options.

ETF options often have strike prices one-point and even half a point wide. This makes spread trading easier for smaller accounts.

Index options, on the other hand, typically list their strike prices in 5-point increments. This can make vertical spreads and iron condors very expensive indeed!

2. ETF Options Have the Best Liquidity

When compared to equity and index options, ETF options offer the best liquidity. Not all of them, of course, but many do.

SPY is the most widely traded security in the US. This makes for tight markets, high volume, and high open interest in the options market, which is good for us.

Equities Explained

Equity (Individual Stock) Definition: In the stock market, Equity represents a piece of ownership in an individual company.

If you own a company’s stock, you own a little piece of that company. This allows for two great benefits: voting rights and the right to receive dividends.

Equity Options Explained

In almost every way shape and form, equity options are identical to ETF options.

1. Equity Options Are “American Style”

2. Equity Options are Settled via Physical Delivery

3. Equity Options Have No Tax Advantages

4. Equity Options Pay Dividends

Perhaps the greatest distinction between ETF and equity options lay in their premiums: overall, equity options almost always have more premium than ETF options.

This is because of something called “implied volatility“.

Implied volatility (IV) helps to determine the price of an option. IV is simply the options market’s expected move for a stock. Since equity stocks are less diverse than ETFs, they have more volatility. This risk increases IV, which in turn increases the price of an option.

Final Word

In conclusion, we have learned that index options are very distinct from the options of ETFs and equities.

For the trader who doesn’t wish to stay glued to their computer, index options offer great benefits.

ETF and equity options are best suited for “hands-on”, small accounts.

Next Lesson

Additional Resources

ETF Options vs. Index Options: What’s the Difference?

What Are Index Options & An Equity Index? – Merrill Edge

Long Put vs. Short Put: Options for Beginners

Posted on January 12, 2022February 24, 2022 by Mike Martin

Last updated on February 24th, 2022 , 06:14 am

	Long Put	Short Put
Market Direction	Bearish	Neutral and Bullish
When To Trade	Best for traders very bearish on a security	Best for traders who believe a security will either stay the same or increase in value.
Maximum Profit	Strike price of the put minus the price of the put	Credit received
Maximum Loss	Entire debit paid	Strike price minus the premium received
Breakeven	Strike price minus the cost of the put	Strike price minus the premium received for the put.
Time Decay Effect	As time passes, and both implied volatility and stock price stay the same, a long put will persistently shed value.	As time passes, and both the implied volatility and stock price stay the same, a short put will shed value – which is desirable for short puts.
Probability of Success	Low	High

Long Put Explained

Long Put Definition: In options trading, a long put is a bearish trade that gives the owner the right to sell 100 shares of stock at the contract’s strike price on or before the options expiration.

Call options give the owner the right to purchase stock. Put options give the owner the right to sell stock.

Therefore, put options are bearish trades.

Beginners often compare buying puts with selling stock – this comparison is far from valid.

When you sell a stock, you profit when that stock falls in value, by any amount.

Put options, on the other hand, not only need the stock to fall to become profitable but the stock must also fall by a lot.

Let’s take a look at an example to understand why.

Long Put Option Example

Let’s say Apple (AAPL) is due to release earnings in 7 days. We believe AAPL will fall post-earnings.

However, we only have 1k in our trading account. With AAPL trading at $170/share, this won’t give us too much exposure by selling stock.

This is when options come in handy. Calls and puts typically have a multiplier of 100×1. This means that one contract represents 100 shares of stock. That’s a lot of leverage!

Let’s take a look at an options chain and choose our strike price.

AAPL Options Chain

Put Strike Price	Premium (Cost)
$170	$4.25
$165	$2.25
$160	$1.40

So let’s say we went ahead and purchased the $165 call for a debit of $2.25. Because of the multiplier effect of 100, the true cost of this trade is $225. Here are our trade details.

Trade Details:

Stock Price: $170
Strike Price: $165
Option Cost: $2.25 ($225)

Let’s first discuss how much we could make on this trade.

Long Put Maximum Profit: Strike price of the put minus the price of the put.

We bought the 165 put for $2.25, therefore, our max profit is (165-2.25) $162.75, or $16,275! This occurs when AAPL is trading at zero on expiration – unlikely!

What about the maximum loss?

Long Put Maximum Loss: Debit Paid.

So our max loss here is our debit paid of $2.25. Seems like a pretty good risk/reward scenario – but options trading is all about probabilities.

Let’s see how our trade actually did on expiration.

Long Put Trade Results

Trade Details at Expiration:

Stock Price: $170 –> $166
Strike Price: $165
Option Value: $2.25 –> $0

So we were right – AAPL fell after earnings. When we bought the put, the stock was trading at $170. It fell by $4 to $166.

But we own the $165 put – this strike price is out-of-the-money on expiration.

Remember, a put option gives you the right to sell stock. Why would you exercise that right to sell stock at $165 when you can sell stock in the market for a better price of $166. Nobody would do this – therefore, on expiration, nobody is willing to buy our put. Its value is zero.

As expiration approaches and the stock price stays the same or mildly fluctuates, options lose value. This is because of the option Greek “theta”, or time decay.

Take a look at the below image, which shows how the premium on a LEAP option (long-term option) compares to that of a near-term option of the same strike price.

So why does the premium dwindle?

Intrinsic and Extrinsic Value in Options Trading

The value of all options is composed of intrinsic and/or extrinsic values.

Intrinsic value is simply the amount an option is in-the-money by. If a stock is trading at $170, and you own a $175 put, the option is in-the-money by $5 – this is its intrinsic value.

Extrinsic value is all value that is not intrinsic value. Implied volatility and time value account for this value.

As time passes, out-of-the-money options lose value. Extrinsic value is what could happen. Earlier, we bought the $165 put on AAPL. If an hour before expiration, AAPL is trading at $170, what are the odds of the stock drpping by $5 in this short amount of time? Slim to none. Therefore, it will not have any “hope”, or extrinsic value during this time.

It is because of this profound time-decay most out-of-the-money options lose value. This is also why most professional traders SELL options.

Short Put Explained

Short Put Definition: The owners of long “American Style” put options can exercise their right to sell stock at any time. When this happens, the short party must be prepared to deliver 100 shares of stock.

You can both buy and sell options. Options sellers are at the mercy of the buyers – at any time, for American options, the owner of an option can exercise their contract. What happens to short puts here?

They must deliver 100 shares of short stock. This leaves the short put party long 100 shares of the underlying. However, options assignment rarely happens.

So, what exactly is a short put? It’s the exact opposite of a long put.

Short put sellers have market conviction the exact opposite of put buyers. They believe the underlying will either go up or stay the same in value.

Remember those detrimental effects of time decay? Well, for short options, time decay works in their favor.

Let’s take the other side of our above trade, and sell that option now.

Short Put Option Example

Put Strike Price	Premium
$170	$4.25
$165	$2.25
$160	$1.40

So in this example, we are going to sell that $165 put instead of buying it.

Trade Details:

Stock Price: $170
Strike Price: $165
Credit Received: $2.25 ($225)

When you sell an option, you receive a credit to your account (as seen above). However, this is not a free trade. Quite the opposite.

When you buy an option, the most you can lose is the debit paid. When you sell an option, that maximum loss scenario increases significantly. It is because of this your broker will require a lot of money held on the side to hold your short position. The cost of margin to sell our above put is over $1k! If the trade moves against us, our broker want to make sure we can cover the losses.

Short Put Maximum Loss: Strike Price Minus Premium Received

So for us, the max loss on this option is $162.75 ($165-$2.25), or $16,275! Remember this number is also the max profit on a long put – this should make sense.

When will this occur? If the stock is trading at $0 on expiration. Unlikely.

How much can we make?

Short Put Option Maximum Profit: Credit Received

Since we received a credit of $2,25, this is the most we can make on selling our put.

Short Put Trade Results

Trade Details at Expiration:

Stock Price: $170 –> $164
Strike Price: $165
Option Price: $2.25 ($225) –> $1 ($100)

So in this scenario, AAPL fell below our short put strike of $165 to $164. At the moment of expiration, our put was valued at $1.

Remembering that we sold this but for $2.25, we can see we made a profit of $1.25 ( (2.25-1).

Why was the put trading at $1 on expiration? Because when an option expires, all extrinsic value is gone. What remains is intrinsic value, which is synonymous with “moneyness”. Our option was in-the-money by $1.

Final Word

Put buying is generally a low probability, high reward trade. Put selling, however, is a high probability, low reward trade.

Over the long-run, selling puts generally makes more money than buying them. But, as stated by optionseducation.org, selling options has great risks. If you’d like to learn more about selling put options for income, please check out our article below!

Next Lesson

Additional Resources

Explaining Put Options (Short and Long) – CME Group

Long Put – The Options Industry Council

Covered Call vs. Long Call: Here’s How They Differ

Posted on January 11, 2022February 11, 2022 by Mike Martin

Last updated on February 11th, 2022 , 06:57 am

Covered calls (aka “buy-writes”) and long calls are very different types of options trading strategies.

In a nutshell, call options are speculative investments that profit when a stock rises substantially in value. Covered calls, on the other hand, are a combination of 100 shares of long stock and a short call. This latter strategy has less market risk (but greater principle risk), and a greater chance of profitability. Additionally, covered calls can profit in any market direction.

Let’s first take a look at the textbook definition of the two, then dive into a few examples.

TAKEAWAYS

Long calls profit in very bullish markets.
The covered call strategy is ideal for market-neutral traders.
A long call consists of buying a single option; the covered call consists of selling one call option AND purchasing 100 shares of stock.
The maximum loss on a long call is the entire premium paid.
The maximum loss on a covered call resides on the stock side, and is calculated by stock purchase price – option premium collected.

What is a Long Call?

Long Call Definition: A long call gives the owner the right, but not the obligation, to purchase 100 shares of stock at a specified strike price on or before a specified expiration date.

Long Call Components: Long call at strike price X.

Long call options provide very bullish investors with great upside potential. When compared to stocks, options are leveraged at a ratio of 100 shares per 1 option contract. This “multiplier effect” magnifies both risk and reward.

Long Call Example

Let’s say Apple is trading at $170/share. You believe that in two weeks, following their earnings report, AAPL will be trading at $185/share.

Here are the details of the call option you purchase:

Initial Trade Details:

➥Stock Price: $170

➥Call Strike Price: $180

➥Call Cost (premium): $2 ($200)

➥Call Expiration: 14 Days Away

So lets say that 2 weeks have passed. Following earnings, the price of AAPL stock soared. How did our trade do? Let’s see.

Trade Details at Expiration:

➥Stock Price: $170 –> $185

➥Call Strike Price: $180

➥Call Value: $2 (200) –>$5 ($500)

➥Call Expiration: Today

As we can see, with the stock trading at $185 on expiration, our call option netted us a nice profit of $300! We purchased this option for $2 and on expiration, it is trading at $5. The difference between these two figures tells us our profit. This value is all intrinsic value.

If the stock was trading under our strike price of $180 on expiration, we would have lost the entire premium of $2 ($200) that we paid.

What is a Covered Call?

Covered Call Definition: A covered call is an income generation options strategy that allows investors to profit from their long shares in a stagnating market.

Covered Call Components: Long 100 Shares of Stock AND Short 1 Call Option

If an investor is either neutral, mildly bullish or mildly bearish on a stock they own, that investor could sell an out-of-the-money call option on that stock to generate income.

As long as the stock price is trading under the strike price of the call sold on the option’s expiration, the investor will collect the entire premium of the option sold.

Selling a call against stock does, however, limit upside potential. If the stock rallies beyond the strike price + value of premium collected, the short call will act as ballast on the long stock, preventing further gains.

Covered Call Example

Lets re-visit our above AAPL trade, but this time, we don’t think AAPL is going to go anywhere.

Unlike our long call option strategy, the covered call must include a short call and 100 shares of long stock. So we will assume we have 100 long shares of AAPL in our account today.

We believe AAPL will be trading under $180 in two weeks. It is currently trading at $170. To generate income from our stock, we will sell an out-of-the-money call. Here are the details of our trade:

Initial Trade Details:

➥Stock Price: $170

➥SHORT Call Strike Price: $180

➥Premium Collected: $2 ($200)

➥Call Expiration: 14 Days Away

So let’s say 14 days have passed. We were right this time – AAPL closed at $176 on the expiration day, below our short call strike price of $180.

Unlike buying calls, when an investor sells a call, they want that call option to go down in value. Here is how our trade played out:

Trade Details at Expiration:

➥Stock Price: $170 –> $176

➥SHORT Call Strike Price: $180

➥Closing Option Value: $2 –> $0

➥Call Expiration: Today

This was an ideal outcome for us. We made $7 per share on the long stock AND collected the full premium of the option sold ($200).

Now, what if the stock rallied instead to $190 on expiration instead? In this scenario, our short call would prohibit additional stock profit at the strike price + premium sold level ($180 + $2 = $182).

In this second outcome, the call option is in-the-money on expiration; an investor can choose to do nothing, and the short call will be exercised, forcing them to sell 100 shares at the strike price of $180/share. The result would be a flat position.

Long Call vs Covered Call: Head-to-Head

	Long Call	Covered Call
When to Trade?	The long call is best suited for traders who are extremely bullish on an underlying security.	The covered call is a great way for investors to collect income on a stock that they believe will change little in the future.
Maximum Profit Potential	Unlimited (there is no cap on how high a stock can go)	Short Call Strike Price - Stock Entry Price) + Option Premium Collected
Maximum Loss Potential	Entire Premium Paid	Stock Entry Price - Option Premium Collected
Breakeven	Strike Price + Premium Paid	Stock Price - Short Call Premium Collected
Time Decay Effect	As time passes, and both implied volatility and stock price stay the same, a long call option will persistently shed value.	As time passes, and both the implied volatility and stock price stay the same, the short call portion of a covered call will shed value, which is desirable as a short option profits when its value falls.
Ideal Market Direction	Bullish	Market Neutral
Tips	In the long run, buying call options is usually a losing battle. For out-of-the-money calls, you need the stock to go up in value - by a lot. Time is NOT on your side here.	The covered call is a great way for all investors to make a little extra money from their stock in a neutral market. Over the long run, however, owning the stock outright is usually more advantageous.

Additional Resources

What Is a Long Call? | The Motley Fool

Covered call – Wikipedia

Intrinsic and Extrinsic Value in Options Trading Explained

Posted on January 6, 2022April 29, 2022 by Mike Martin

Last updated on April 29th, 2022 , 10:06 am

The premium composition of all option contracts (derivatives) can be broken down into one of two values: intrinsic and/or extrinsic value.

Understanding the fundamental difference between these two values is vital for the success of any options trader. These values are the building blocks upon which other options trading narrative builds as they determine the price of an option.

Let’s get started!

TAKEAWAYS

An option’s value is comprised completely of intrinsic value and/or extrinsic value.
Intrinsic value is simply the amount an option is in-the-money by.
Extrinsic value represents all option premium that is not intrinsic value.
Extrinsic value consists of 1) time value and 2) implied volatility.
Because of time value, an options extrinsic value will diminish as expiration approaches.
Options with high implied volatility will have greater extrinsic value than identical options with lower implied volatility.

An Option's Two Price Components

The value of any options contract – ETF options, equity options and index options – is the summation of its intrinsic and extrinsic value:

Option Price = Intrinsic + Extrinsic Value

The above image shows us how these values shift within an option as that contract progresses through time, reacting to changes in the price of the underlying security, the passing of time, and implied volatility.

What is Intrinsic Value?

Intrinsic Value Definition: The value an option has in itself should that option be exercised immediately.

When compared to extrinsic value, intrinsic value is straightforward and easy to calculate.

The word “intrinsic” comes from the French word intrinsèque, which means “inwardly”. Intrinsic value is therefore the “inward” value of an option, discounting time and future volatility.

If an option were to be exercised at the moment of observation, would that option have value? If the option were in-the-money, yes. Therefore, in-the-money options have intrinsic value

Out-of-the-money (OTM) options, since they have no immediate value, have zero intrinsic value.

Let’s take a look at a few examples of intrinsic value and call options:

Calls and Intrinsic Value

The above table shows us three different call options. The first option listed has a strike price of $150. Since the current stock price is $200, this option has an intrinsic value of $50 ($200 – $150 = $50).

To determine the intrinsic value of any option, simply subtract the strike price from the stock price.

This calculation will tell us how much value that an option has should it be exercised immediately.

What about the above $210 strike price call? $200-$210 would give us -10. But extrinsic value can not be below zero, therefore the extrinsic value of this option is zero.

Intrinsic value discounts time: it tells us what an option would be worth at any given moment assuming expiration is already here. If the expiration date were here, what value would a $210 call have with the stock at $200? Considering that we can buy the stock cheaper in the open market ($200), this option has zero intrinsic value.

What is Extrinsic Value?

Extrinsic Value Definition: The value of an option that exceeds its intrinsic value.

In short, extrinsic value is everything that is “leftover” from intrinsic value. This value is the “premium” associated with the potential for an option to become more valuable before it expires.

We remember that intrinsic value shows us the immediate value of an option should that option be exercised immediately.

But, if that option has time until it expires, shouldn’t that option’s value reflect what could happen to it during the duration of its life?

For this reason, extrinsic value is also known as “time value“.

Let’s take a look at an example:

Calls and Extrinsic Value

We mentioned above that an option’s extrinsic value is everything that is leftover from its intrinsic value. We can see the $150 strike price call is trading at $52. Since we know the intrinsic value to be $50, the extrinsic value must therefore be $2.

This $2 represents the options “time value“, or its premium to change as the option approaches expiration.

Notice how the $210 call has zero intrinsic value. Why is this? This option is out-of-the-money. These types of options have zero intrinsic value and therefore consist of 100% extrinsic value or time value.

Let’s do a quick recap of intrinsic value for calls.

Intrinsic Value for Calls

Call Intrinsic Value:

The value of being able to buy shares at the call’s strike price.

Stock Price Above Call Strike Price:

Call Intrinsic Value = Stock Price – Call Strike Price
Example: 140 call on $150 stock = $10 Intrinsic Value

Stock Price Below Call Strike Price:

Call Intrinsic Value = Zero
Example: 225 call on $200 stock = $0 intrinsic Value

Intrinsic vs. Extrinsic: In-the-Money-Call

The above image illustrates how the intrinsic and extrinsic value of an option with a 105 strike price changes over time.

We learned before that only in-the-money options have intrinsic value. Therefore, this option will only have intrinsic value when the stock is trading above 105.

When the option is trading below this 105 strike price, its entire premium is comprised of extrinsic value.

Stock > 105: Call Has Intrinsic Value
Stock < 105: Call Is All Extrinsic Value

Notice how this option has its most extrinsic value at 73 days to expiration? Remembering that extrinsic value is synonymous with “time value”, this should make sense.

Notice too how the options extrinsic value falls when the option is “in-the-money” (ITM). During this period, a portion of an options value must be contributed to intrinsic value.

As time passes (and expiration nears), extrinsic value diminishes, leaving only intrinsic value.

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

The above image shows how the premium components of an out-of-the-money call shift over time as the underlying stock price changes.

Stock > 195: Call Has Intrinsic Value
Stock < 195: Call Is All Extrinsic Value

With the exception of the very first few days, this option is widely out of the money for the duration of its life.

As expiration approaches, extrinsic value diminishes, leaving only intrinsic value. Since out-of-the-money options have no intrinsic value, this option is fated to expire worthless.

Just as in our previous example, extrinsic value (aka time value) sheds as expiration approaches.

Intrinsic Value for Puts

Hopefully, by now, you have a pretty good idea of that which comprises a call options value.

But what about put options?

Put Intrinsic Value:

The value of being able to sell shares at the put option’s strike price as opposed to the current stock market price.

Stock Price Below Put Strike Price:

Put Intrinsic Value = Put Strike Price – Stock Price
Example: 165 Put on a $150 Stock = $15 of Intrinsic Value

Stock Price Above Put Strike Price:

Put Intrinsic Value = Zero
Example: 300 Put on a $325 Stock = $0 Intrinsic Value

Intrinsic vs. Extrinsic: In-the-Money Put

In order to understand the pricing components of put options, we only need to take everything we learned about calls – then flip this information on its head.

Stock > 190: Put is All Extrinsic
Stock < 190: Put Has Intrinsic

Just as with call options, an option’s extrinsic value (aka time value) diminishes as time passes and expiration approaches.

At the moment of expiration, put options will consist of 100% intrinsic value or have “0” value if the option is out-of-the-money.

At the moment of expiration, the above stock price was trading at about $170. Since we are long the 190 put, that puts our option in the money by $20 (190-170). By looking at the lower chart, we can indeed see that this was the closing price of the option on the expiration day.

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

In this last example, we are going to look at the intrinsic and extrinsic value of a 80 strike price put that is out-of-the-money for its entire life.

Stock > 80: Put is All Extrinsic
Stock < 80: Put Has Intrinsic

Just as with our out-of-the-money call example, we can see this option shedding value as expiration nears.

Additionally, our 80 strike price put was never in-the-money. Therefore, it never had intrinsic value.

On expiration day, the stock was trading at about $100 – not even close to our $80 strike price. Therefore, the option will expire worthless.

What Determines the Amount of Extrinsic Value?

The extrinsic value of any option is comprised of two components.

#1: Time to Expiration

An options days to expiration (DTE) is the first factor that determines an option’s extrinsic value.

Longer-Term Options = Greater Extrinsic Value

As a rule, extrinsic value increases with greater DTE. These options are more expensive than front-month options because there is more time for the stock to reach or exceed the strike price.

If a stock is trading at $100, and you own a $110 call going into expiration day, there is little chance the stock has the time to reach this level. If you own a $110 strike price call that expires in 6 months, however, the stock still has sufficient time to reach these levels, and will therefore have considerably more extrinsic value.

The above image illustrates how the extrinsic value of an at-the-money (ATM) call diminishes as expiration approaches. Remember, at-the-money calls are not in-the-money, so are therefore comprised of 100% extrinsic value.

#1: Implied Volatility

In options trading, implied volatility is the market’s prediction of the future movement in a security.

Higher Implied Volatility = Greater Extrinsic Value

The more an underlying asset is expected to move, the greater the premium the options on that underlying will be.

The above image shows us how implied volatility impacts the prices of an at-the-money call option experiencing various implied volatility levels.

With implied volatility (IV) of 15%, the option is only trading at $1.71. Increase that IV to 50%, and the options jacks up to over $5 in value.

This should make sense. Think about Tesla (TSLA) stock vs. Johnson & Johnson (JNJ).

Tesla is known for its volatile swings. It, therefore, has a greater chance of reaching distant strike prices than that of JNJ. To reflect this probability, TSLA has higher implied volatility than JNJ.

Intrinsic vs Extrinsic Value: FAQs

Why do options have extrinsic value?

Options have extrinsic value to account for time value and the implied volatility of the underlying. Intrinsic value tells us how much value an option has in itself; extrinsic value tells us how much value an option has taking into account the unknown. Understanding these two values is very important when trading options.

What does intrinsic value mean in options?

Intrinsic value tells us how much value in option has if it were to be exercised at this moment of observation. Therefore, only in-the-money options have intrinsic value. This value ignores “time” and “implied volatility”.

Final Word

The entirety of an option’s premium consists of intrinsic and/or extrinsic value.
Intrinsic for Calls: Stock Price – Call Strike Price
Intrinsic for Puts: Put Strike Price – Stock Price
Extrinsic value is everything left over after accounting for intrinsic value.
Extrinsic value consists of 1) time decay and 2) implied volatility.
Extrinsic values declines as expiration approaches.

Next Lesson

Additional Resources

Option Pricing: Models, Formula, & Calculation – Investopedia

Intrinsic and Extrinsic Value – Medium

Call Options vs. Shares: 6 MAJOR Differences

Posted on January 4, 2022February 24, 2022 by Mike Martin

Last updated on February 24th, 2022 , 09:05 am

There are some pretty significant differences between buying call options and buying stocks. Before we examine how these types of securities differ, it may first help to understand a few ways in which they are alike.

1.) Both long calls and long stock positions are bullish.

If you purchase a stock, you anticipate that stock will go up in value. If you purchase a call option on that same stock, you are also bullish. However, call option buyers are much more bullish than stock buyers.

2.) A call option can “trade like” a certain amount of shares.

In options trading, the “Greeks” are a series of calculations traders use to determine how an option will react to various market movements. The Greek “Delta” tells traders how an option will react to an immediate $1 move in the price of the underlying security.

Delta also tells us how many shares of stock an option “trades like”. If a call option has a delta of .50, this tells us this option will trade like approximately 50 shares of stock. Unlike stock, however, the option Greeks are in constant flux with time and volatility.

Now that we understand the limited ways in which these types of securities are similar, let’s now explore how stocks differ from options.

TAKEAWAYS

For long-term investors, stocks tend to out-perform call options.
Stock (or equity) comes with certain rights, such as the right to receive dividends. Call options have no such rights.
Options are usually leveraged at a ratio of 100:1, meaning one contract represents 100 shares of stock.
If the price of a stock remains the same, a shareholder will not lose money. Call options shed value as time passes if the stock remains the same.
All call options will expire at some future, pre-specified date (expiration date)
In theory, stocks have greater principle risk than options.

1) Stock Represents Ownership

When you buy a share of a company’s stock, you are buying a piece of that company. This is known as “equity”.

Having “equity” in a company comes with certain benefits:

Options contracts are “derivative” instruments. This means their value is derived from the underlying security. Though the owner of a long call does indeed have the right to convert their contract to 100 long shares at any time, until this “exercise” happens, they have none of the rights that stock owners have. In the eyes of the company, they do not exist.

In fact, call options actually go down in value when a stock goes “ex-dividend”.

2) Call Options Offer Leverage

As explained by FINRA, options are standardized contracts. This standardization allows for greater market liquidity and regulation.

Part of an options standardized terms pertains to the “multiplier effect”.

Option Contract Multiplier Definition: Standard call and put options have a multiplier of 100, meaning that one contract represents 100 units or shares of the underlying stock, exchange-traded fund (ETF), or index.

To better understand how option leverage works, let’s look at an example from the tastyworks trading platform:

Buying 100 Shares of AMZN

The above image shows an order to buy 100 shares of Amazon (AMZN) stock. The cost of this trade? Over 340k.

Now, let’s take a look at an at-the-money call on AMZN expiring in a few days.

At-The-Money AMZN Call

The above shows an order ready to buy a call option on AMZN.

We said earlier that a call option delta shows us “how many” shares of stock a contract mimicks. This call option has a delta of about 50. If we were to buy two of these calls, our delta would match that of 100 shares of stock!

Cost of 100 AMZN Shares: $341,000
Cost of 2 ATM Call Options: $7,330 ($3,665 x 2)

As you can see, by using options we can get the same exposure to AMZN for a significantly reduced price when compared to buying the stock.

Sound too good to be true? That’s because it is! Options come with significant risks. One of these risks is “time decay“. Let’s explore the detrimental effect of time decay next.

3.) Call Options Experience Time Decay

If you were to purchase 100 shares of AMZN at $3,405 per share, and if in one week AMZN was still trading at $3,405, you would neither have made nor lost money.

However, if you purchased an at-the-money 3,405 strike price call on AMZN last week, and the stock was unchanged when the option expired, you would lose 100% of the premium you paid. For us, that would mean a total loss of $7,330. Though options trading does offer leverage, you indeed pay for this privilege!

I prefer trading vertical spreads to hedge some of this risk.

Time decay is also known as “theta”, which is another option Greek (we already know delta!).

The below table shows the theta for options on AAPL:

AAPL Options Chain

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

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

The above theta value shows us how much the each corresponding AAPL call option will decline in value with every passing day. This assumes an environment of constant implied volatility and stock price.

To go in-depth on theta, check out our video below!

4) All Call Options Expire

One of the standardized terms of an options contract is its expiration date. All options expire. Some options expire in hours, other expire years into the future (these are known as Long-Term Equity Anticipation Securities (LEAPS)).

Stocks never expire. Eventually, most companies will become defunct either through bankruptcies or mergers, but the stock itself does not have a prearranged expiration date.

Options are decaying assets. In a constant environment, they are persistently shedding value (as we learned above).

The below image shows how the value of an option slowly sheds as the stock remains the same and expiration approaches.

5) Call Options vs. Stock: Principal Risk

From a total risk perspective, call options have less principle risk than stock.

Now, this can indeed be misleading We are looking at this through a theoretical lens; or a “worse case scenario” perspective.

Let’s revisit our AMZN example above. Remember, we spent $7,330 to buy 2 call options that gave us the same exposure to AMZN as 100 shares of stock. This stock cost us $341k.

Shares Maximum Loss: $341,000
2 ATM Call Options: Maximum Loss $7,330 ($3,665 x 2)

If AMZN were to plummet to $0 in value overnight, we would lose A LOT more on the stock than the options.

However, AMZN will most assuredly not be trading at $0 in the next few days. Therefore, this perspective is not very reasonable. But it is possible!

6) Call Options vs. Stock: Liquidity

Stock Market Liquidity Definition: The ease in which a security can either be entered or converted into cash.

Generally speaking, equities have better liquidity than options. When trading stocks, we are usually only concerned with two aspects of liquidity: daily volume and the bid/ask spread.

The below image (taken from the tastyworks trading platform) shows the current market for Tesla (TSLA) stock.

The above image shows we can purchase TSLA stock for $1,189.23 and immediately sell it for 1,188.42.

Considering the stock is trading 1k+, that is a pretty tight market.

What about options on TSLA?

TSLA Call Options Liquidity

When we are looking at options, we need to add a few more liquidity variables:

Open Interest (total options outstanding)
Volume (total options traded all day)
Spread (bid-ask difference)

The 1175 call option on TSLA is bid at $92.10 and offered at $95.15.

This means that if we were to immediately buy and sell this option, we would lose $3.05.

When compared to the stock, the liquidity on options is almost always worse.

It is therefore important to always try and get filled at the mid-price when placing an options trade. Never use market orders on options. Slowly work call (and put) option orders in nickel increments, until you are filled.

If the open interest and volume on a particular option series is low, it is best to avoid those options altogether.

Final Word

Perhaps the greatest distinction between call options and stocks is the risk: options have inherently more risk than stocks.

Stocks are generally held as long-term investments; options are short-term “trades” that require diligence and maintenance.

Let’s conclude our article by going over a recap of what we learned.

Stocks pay dividends; options don’t
Call options offer a 100:1 ratio
As time passes, call options decay in value
All call options will expire
Options have less principle risk than stocks
Stock have better liquidity

Next Lesson

Additional Resources

Call options basics – Fidelity Investments

Options Trading: Investopedia

Basic Option Gamma Example

Gamma of Calls and Puts

Option Gamma and Probabilities

Which Options Have the Most Gamma Risk?

Option Gamma and "Moneyness"

Option Gamma vs. Time to Expiration

At-the-Money Option Gamma Near Expiration

ITM & OTM Option Gamma Near Expiration

Next Lesson

What is Option Delta? Ultimate Guide w/ Visuals

Delta Hedging Explained (Visual Guide w/ Examples)

Option Greeks Explained: Delta, Gamma, Theta & Vega

Additional Resources

What is Delta Hedging?

Basic Delta Hedging Example

Delta Hedging in Detail

Visualized Delta Hedging Examples

Trade Example #1: Hedging Long Stock With Long Puts

Trade Example #2: Hedging Short Stock With Long Calls

Delta Hedging FAQs

Next Lesson

What is Option Delta? Ultimate Guide w/ Visuals

Long Gamma and Short Gamma Explained (Best Guide)

Option Greeks Explained: Delta, Gamma, Theta & Vega

Additional Resources

Long Iron Condor Characteristics

Long Iron Condor Profit/Loss Potential at Expiration

Long Iron Condor at Expiration

Long Iron Condor Trade Examples

Trade Example #1: Partial Loss on an Iron Condor Purchase

Long Iron Condor #1 Trade Results

Trade Example #2: Max Profit Iron Condor Purchase

Long Iron Condor #2 Trade Results

Trade Example #3: Long Iron Condor Gone Wrong!

Long Iron Condor #3 Trade Results

Long Iron Condor: Pros and Cons

Final Word

Long Iron Condor FAQs

Next Lesson

29 Core Options Strategies

Short Iron Condor Explained – The Ultimate Guide

Option Greeks Explained: Delta, Gamma, Theta & Vega

Leverage in Options Trading Explained

Additional Resources

Bull Call Spread Strategy Characteristics

Bull Call Spread Profit/Loss Potential at Expiration

Bull Call Spread Trade Examples

Bull Call #1 Results

Unprofitable Call Spread Example

Bull Call #2 Results

Profitable Call Spread Example

Bull Call #3 Results

Final Word

The Vertical Spread Options Strategies: Beginner Basics

Iron Condor Options Strategy for Beginners

Additional Resources

Next Lesson

Exercise and Assignment Examples

Automatic Exercise at Expiration

What if You Don't Have Enough Available Capital?

Why Options are Rarely Exercised

7% Of Options Are Exercised

Who Gets Assigned When an Option is Exercised?

Visualizing Assignment and Exercise

Assessing Early Option Assignment Risk

Final Word

Next Lesson

Options Trading for Beginners

Intrinsic and Extrinsic Value in Options Trading Explained

Option Greeks Explained: Delta, Gamma, Theta & Vega

Additional Resources

Market Index Explained

Index Options Explained

Exchange-Traded Fund (ETF) Explained

ETF Options Explained

ETF Options Advantage Over Index Options

Equities Explained

Equity Options Explained

Final Word

Next Lesson