Options trading can be pretty complicated for new traders. This is a simple breakdown of the anatomy of a stock option. For a more detailed description of options click here.
An Option is a contract that issues rights to traders to buy or sell an asset with a preset timeframe & price. The 2 fundamental types of Options Trading are Calls & Puts. Call Option – A contract that provides the right to buy or shares of a security at a given price by a set date. Put Option – A contract that gives a buyer the right to sell the stock at a strike price by a specific date.
The 3 main drivers of option value are: Volatility – The higher the stock’s volatility, the greater the value of an option. Time – Generally the more time left until expiration, the greater the value. Direction – The direction the underlying stock trades will affect the value.
Anatomy of an options contract
The Ticker of the stock that the option contract is derived from.
The Expiration Date of the option contract.
Strike Price is defined as the price at which the holder of an option can buy or sell the stock when the option is exercised.
Type of Option Call (Long), or Put (Short).
Premium cost of the option, usually represents 100 shares. Pay $1,050 plus commissions for 1 contract (in this case) ($10.50 x 100 = $1,050.00)
The Option Greeks
Delta represents the sensitivity of an option’s price when the underlying security changes.
Here’s 3 things to keep in mind when using Delta:
- Delta tends to increase closer to expiration for near or out-the-money options contracts.
- Delta is further broken down by Gamma, which measures the Delta’s rate of change.
- Delta can also change when reacting to implied volatility changes.
Theta represents the rate of time decay of an option.
Here’s 3 things to keep in mind when reading Theta:
- Theta can be high for out-of-the-money options if the contract carries a lot of implied volatility.
- Theta is usually highest for at-the-money options because less time is needed to profit with a price move in the underlying.
- Theta will increase as time decay speeds up in the last few weeks before the expiration date and can severely undermine a long option position, especially when implied volatility declines at the same time.
Vega represents an option’s sensitivity to volatility.
Here’s 3 things to keep in mind when reading Vega:
- Vega can increase or decrease without price changes of the underlying security, due to changes in implied volatility.
- Vega can increase in reaction to quick movement in the underlying security.
- Vega drops as the option gets closer to expiration.
Gamma represents the rate Delta changes relative to the price of the underlying security.
Here’s 3 things to keep in mind when reading Gamma
- Gamma is the smallest for deep out-the-money and deep-in the-money options contracts.
- Gamma is the highest when the contract gets close to being in-the-money
- Gamma is positive for long options (calls) and negative for short options (puts).
Rho represents how sensitive the price of an option is relative to interest rates. Rho can also refer to the aggregated risk exposure to interest rate changes that exist for a portfolio or book of multiple options positions.
Rho is usually considered the least important of all the Options Greeks.
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