Options Trading Guide
Table of Contents
What Is An Options Contract
1 options contract gives you the right to buy 100 shares at $XX strike price on XX/XX/XXXX expiration date.
Traders use options to trade because it increases their leverage and amount of money they can trade with.
For example:
AMD is currently trading at $102.
5 shares would cost $510.
2 weekly options contracts at $102 strike price are currently priced at $2.50. 1 contract = 100 shares so each contract costs 100 * $2.50 = $250.
Therefore, 2 contracts would cost $500, the same price as 5 shares. However, the options contracts allow you to trade 200 shares for the same price as 5 shares. Hence, more leverage and more leverage means bigger returns on smaller price movements.
Sounds like a no-brainer. So what’s the catch? There is a time decay on the contract. That means as time passes, the contract’s value decreases. This is called theta decay.
With increased leverage, comes increased risk. If this $102 Strike AMD contract is trading “Out of the Money” after expiration, or price below $102, then the contract is worth nothing.
Options Basics
The Underlying
The stock of which the option premium is based off of. The underlying of an AMD $150 Call Contract is AMD stock itself.
Expiration Date
Contract expiration date. Also referred to as “Days Until Expiration” or DTE. If today is Monday, October 23, and a contract has a Friday, October 27 expiration date, then you have 4 days until expiration, or 4-DTE.
Strike Price
The price at which the underlying most close above or below to be considered in or out of the money. For calls, price must close above the strike to have any value at expiration.
Premium
Cost per share of an options contract. This is what you pay to buy 1 contract. Remember, each contract is worth 100 shares. If premium = $2.00, then 1 contract will cost $2.00 * 100 = $200. Premium pricing accounts for volatility and time decay, among other algorithms. If AAPL is releasing their earnings report tonight, then the premiums will be higher than normal because market makers are expecting a bigger than normal move prior to expiration.
Intrinsic Value
Intrinsic value is the value any given option would have if it were exercised today.
Intrinsic Value of a Call = Underlying Price – Strike Price
Intrinsic Value of a Put = Strike Price – Underlying Price
Example Call Option:
AAPL Strike = $200, AAPL Underlying = $205.00
The intrinsic value of the contract would be $205 – $200 = $5.00
Breakeven Price
Share price at which contract would break even.
Breakeven Price of Call Option = Strike + Avg Premium Cost
Volume
The number of contracts bought or sold on a given trading day.
Open Interest
The number of open contracts at the beginning of a given trading day.
Bid-Ask Spread
The difference between the Ask and Bid price of an options contract. The tighter the spread, the higher the liquidity. Look for $0.05-$0.15 spreads.
Liquidity
The ease at which contracts can be bought and sold. High liquid contracts allow you to exit and enter contracts quickly at or near market prices. If you’ve ever entered an options contract and were immediately down 15% you likely entered an illiquid contract. That is not good.
Liquid contracts allow you to enter and exit at market prices which can help you practice good risk management including using market stop loss orders.
Theta
The rate of decline in the value of an option over time. If all other variables are constant, an option will lose value as time draws closer to its maturity.
Delta
How much an option’s price can be expected to move for every $1 change in the price of the underlying security or index.
Example Contract
AAPL 10 JUNE 2022 $150 Call at $3.00
AAPL = Ticker
Underlying ticker. Premium pricing will react to AAPL price changes.
10 JUNE 2022 = Expiration Date
Date at which the contract will expire. The contract must be closed prior to market close on this date. Keep in mind, you can close your contracts prior to the expiration date.
$150 = Strike Price
Price at which the contract will be deemed worthless. For Calls, AAPL underlying price must close above $150 on said expiration date. If this were a Put contract, AAPL underlying would have to close below $150 on said expiration date.
Call = Long or Short
Call = Long, Expect AAPL underlying price to INCREASE.
Put = Short, Expect AAPL underlying price to DECLINE.
$3.00 = Premium
Cost of the contract per share. Remember, each contract contains 100 shares. If we bought 3 – AAPL 10 JUNE 2022 $150 Calls at $3.00 then we’d be paying:
3 Contracts * $3.00 Premium * 100 Shares = $900
Premium is what is traded compared to share price in normal trades. If premium increases from $3.00 to $4.00, you have a 33% return.
How to Choose an Options Contract
1. Choosing Expiration Date
For day trading, choose an options contract between 0 – 5 Days until Expiration (DTE). You should not swing these contracts overnight. 3-DTE means you have 3 full trading days until your contract expires. If you’re completely new to day trading options, paper trade or add an extra week.
2. Assure Contracts are Liquid
Liquidity is the amount of money trading hands. There are 3 liquidity metrics you should be aware of:
Volume = the amount of contracts bought and sold on said trading day
Open Interest = the number of open contracts at the open of said trading day
Ask-Bid Spread = the difference between the ask and bid price; the tighter the spread, the higher the liquidity
The Ask : the price at which contracts are bought
The Bid : the price at which contracts are sold
Look for high numbers in Volume and Open Interest. The contracts with the most liquidity will have the highest Volume/OI ratio.
The quickest way to check for liquidity is a tight Ask-Bid Spread. Look for $0.05-$0.10.
Example: AAPL $150 Strike
Ask Price = $1.10
Bid Price = $1.05
Spread = $0.05 = Excellent.
3. Picking a Strike Price
Instead of picking a strike price, pick a Delta value. Delta measures how much an option’s price can be expected to move for every $1 change in the price of the underlying.
Delta ranges between 0 and 1. Choose a Delta between 0.40 and 0.60. The closer you get to 0, the more volatile and risky your contract is. I think of delta like this:
0.40 Delta = 40% chance of the option expiring In the Money (ITM).
Something else to consider when picking a strike price, especially with 0 or 1-DTE is ITM versus OTM. The closer you get to expiration, the more seriously you should consider trading ITM contracts. For 0-DTE, I strictly trade ITM or right below the money which usually aligns with a greater than 0.50 delta.
TLDR
1. Choose an Expiration Date
0-5 DTE for day Trading
2. Check for Liquidity
Use the tickers mentioned in Clinical Trading Mastery and you’ll never have an issue: AAPL MSFT NVDA AMD TSLA AMZN QQQ SPY. Otherwise Ask-Bid Spread should be less than or equal to $0.10
3. Choose a Strike Price
Pick a delta between 0.40 and 0.60 instead with 0.40 being more risky. If you are trading 0-DTE, pick an ITM strike price. The deeper ITM the strike is, the safer it is.
BONUS: Trading 0-DTE “Lottos”
Picking a strike price with Delta > 0.4 and ITM is even more crucial. Dips will crush you.
Trading “lottos” is a different ballgame. You have to be extra careful and it’s essential that you trade greater than 0.40 delta contracts. I’d also highly recommend ITM strike prices with 0.50 deltas. Theta decay occurs quickly and dips in price action will wipe out a good portion of premium trading OTM and even ITM sometimes.
I’d recommend using a 40% stop loss so adjust your sizing accordingly. I’d even recommend using your account risk as your full position size meaning you trade with no stop loss and you risk your position going to zero. If you have a $10,000 account and risk 5% of the account your position size is only $500 allowing you to lose 100%.
With that being said, as DTE decreases it is a good idea to reduce position size regardless.
