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Options trading is a skillset that typically takes a few weeks to a few months to learn. The numbers and strategies can be intimidating initially, but don’t be discouraged. If the option chains, Greeks and terminology seem complicated at first, there are tools such as OptionsPlay and ongoing education from the Montréal Exchange to help simplify options for beginners! To learn how to get started with trading options, please view our recent webinar
There are 2 basic strategies that options traders should learn before they start trading: writing covered calls (income) and buying calls and puts (speculation).
Writing covered calls:
Writing covered calls is an income-generating strategy used for stock or ETF holdings in an equity portfolio. This strategy requires holding at least 100 shares and writing an “out-of-the-money” (OTM) call option. An “out-of-the-money” call option is one with a strike price above the current stock price. The writer of a call option is obliged to sell his or her stock at the strike price of the call option upon expiration. The goal of this strategy is for the option to expire worthless with the stock below the strike price at expiration, thereby allowing the investor to keep the income from writing the call option. When this happens, the investor can continue writing covered calls to generate a stream of income from his/her equity portfolio through a series of expirations! In the event that the stock price is higher than the strike price upon expiration, the stock is sold to the buyer of the call option at the strike price. Here are some tips and best practices to follow to avoid the common mistakes made by beginners:
- Do not write aggressive calls– This refers to writing call options that have a strike price that is too close to the current market price, as there is a higher probability of the stock reaching that strike price.
- 2.Write options with short expirations – Writing options that expire within a month. Longer expirations are tempting, as they deliver more income to the option writer. However, longer dated options deliver income at a slower pace compared to writing short-dated options more frequently.
- Avoid earnings announcements– Earnings announcements cause stocks to experience extreme volatility, and this can cause the price of the stock to reach the option’s strike price in a short period of time.
To learn more about covered calls (Link to Covered Call Blog Post)
Buying calls and puts is an option strategy that is used for speculation purposes (based on a bullish or bearish view on a stock or ETF). If an investor has a bullish outlook on a stock or ETF, buying a call option can provide upside exposure. Conversely, for a bearish outlook, an investor could buy a put option to profit from a potential downside move. When buying calls or puts, it is best practice to use expirations that are at least 1-2 months from expiry and with “at-the-money” strikes (a strike price that is close to the current market price). Novice options investors tend to make certain mistakes, but following some of these tips will help you avoid them:
- Do not hold a long option position until expiration– Unlike stocks, options have an expiry date. This means that the value of the option will decrease over time. Theta, which measures the rate at which an option’s price will erode over time, is discussed in further detail below.
- Do not purchase options with a very short expiration – If you believe that a share price will rally 5% in 2 weeks, consider an option with an expiration of 4 or 5 weeks. This will give you a buffer in the event that the stock takes longer than expected to rise 5%.
- Always have an exit plan– Set a target and stop-loss level on the stock price, and exit your option position when one of them is triggered. Holding onto an option position longer than necessary will result in time decay (theta), which will erode your gains or magnify your losses!
Understanding the Greeks
The Greeks are variables used to measure factors affecting the price of an option. At first glance, the Greeks can be intimidating to new option traders. Buying stocks is much easier to understand, due to the dollar-for-dollar exposure, but options are not as straightforward. While the Greeks are not as complicated as they may initially seem, it is important for traders to understand how they work on a conceptual level. The two most important Greeks are “Delta” and “Theta”:
- Delta – Delta refers to the rate of change in an option’s price with respect to small changes in the underlying stock price. For larger moves in the underlying stock price, an additional Greek, Gamma,needs to be considered. For example, buying a call option with a Delta of 0.5 signifies that the value of the option will increase by $0.50 if the stock moves $1 higher. Delta is calculated as follows:
Delta = Change in option price/ Change in stock price (for small changes in the price of the underlying)
- Theta – Theta refers to the rate of change in the option price with respect to time, with other factors remaining constant. As options have an expiration date, an option’s price will decay as it approaches expiration. Theta tells us the rate at which an option’s price will decay over time. When buying options, it is best practice to exit the position as quickly as possible to minimize the effect of time decay eroding your gains and magnifying your losses. Theta is calculated as follows:
Theta = Change in option price/ Change in time (when other factors such as the price of the underlying are held constant)
Using the tips and best practices mentioned above should help you understand your first options trade. While there is always more to learn, being comfortable with the basic strategies and terminology will help you acquire a solid educational foundation. Please view the following webinar that we have recently developed to help you get started with options trading.
Register for free access to OptionsPlay Canada to jump-start your options trading: www.optionsplay.com/tmx
Disclaimer: The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.
There are so many benefits and usages with options, the sky’s the limit. If you wish to learn more about options and what they can offer. There are lots of educational material on the Montreal Exchange website.
This document is a translation of the original in English, for information purposes only. In case of a discrepancy, the English original published by Bourse de Montréal Inc. shall prevail. The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.