CBOE Options courses
The CBOE courses are frequently cited as a great free resource for people interested in understanding the practicalities of option trading.
In these notes, I have frequently borrowed images from Daniels Trading, which has succinct overviews of various strategies (including example scenarios and calculations).
Language of options
- An option class is the set of all options on a security, usually represented by an options chain.
- within a class, the type can be a put or call
- a series specifies the options with a given strike and expiry, e.g. SPY Apr 300 calls.
- Every stock is assigned one of three expiration cycles:
- Jan cycle: Jan, Apr, Jul, Oct
- Feb cycle: Feb, May, Aug, Nov
- Mar cycle: Mar, Jun, Sep, Dec
- All optionable stocks have at least 4 contracts:
- the next two calendar months (forward months)
- the next 2 months in the cycle
- some stocks have two additional LEAPS expiring on the next 2 Januaries
- If you sell an option and get assigned, you have 2 days to settle. Early assignment is a risk for any short American option.
- All equity options are American, most index options are European.
Introduction to option pricing
- Options are conceptually very similar to insurance:
- puts can protect long positions in the underlying
- calls can be thought of as “insurance” on cash positions, making sure that they participate in a price rise
- insurance contract are priced based on the value of the underlying, the deductible (i.e strike), the length of the policy, and the risk.
- Higher interest rates mean higher call prices: the option is more valuable because you are happy to sit in cash and collect money. The opposite is true for puts.
- Dividends affect option prices in a manner opposite to that of interest rates.
- Even when the stock price is equal to the strike price, the call value will be higher than the put. This asymmetry is due to the interest component in the call (you can collect interest on your cash) which is not in the put.
- Time decay (theta) is nonlinear – it accelerates towards option expiry.
- Delta is the amount by which the value of an option changes for a \$1 change in the price of the underlying.
- delta is a dynamic quantity and depends on strike.
- OTM calls have deltas between 0.0-0.5, ATM 0.50, and ITM 0.5-1.0.
Implied volatility (IV)
- IV is the value of the volatility which results in the option value being equal to the current market price.
Basic strategies with index options
- Bullish but afraid of near-term downside: index calls and money market fund.
- want to buy an index fund but hedge against near term loss
- buy calls on a dollar-for-dollar basis (based on the strikes) and deposit our principal into a money market fund.
- if the index appreciates, our call pays off and the result is that we have the same amount of exposure as if we had waited. If the index falls, we get to buy the index at the cheaper price, having only lost the premium.
- Seeks upside participation with low capital: index calls and save.
- buy a long term index call to control a large exposure with a small premium (useful if index has a prohibitively high price)
- save your income in the mean while; at the end of the period, you will have enough to buy the underlying
- Owning a stock, want to take profit if price rises or buy more if prices fall: covered straddle
- consists of long stock, cash, and a short straddle. Calls and puts in the straddle 1-for-1 with the long stock.
- short calls are covered by the underlying; short put are covered by the cash.
- if the stock price falls/rises, the put/call is assigned
- in the mean time, you collect the premium.
- Want to break even on a paper loss without committing additional capital: stock repair
- long 1 ATM call, short 2 OTM calls with strike at the breakeven (a call ratio spread)
- this position appreciates more rapidly with respect to an increasing stock price than just the long stock, but gains are capped at the breakeven
- Aggressive bull: ITM LEAPS
- rather than buying shares on margin, you can buy ITM LEAPS
- these have a lower up-front cost, a substantially lower max risk (no margin calls), but a slightly lower delta.
- with LEAPS, you can’t vote nor receive dividends, but these are rarely relevant for the aggressive bull.
Backspreads and ratio spreads
- Backspreads are variants of vertical credit spreads that involve buying more of the high strike calls, or low strike puts (i.e buying more of the “hedge”).
- Ratio spreads (a.k.a frontspreads) are variants of vertical debit spreads, e.g. a call ratio spread is a bull call spread with more short calls than long while a put ratio spread is a bear put spread with more short put spreads. Ratio spreads include one more more naked short options by definition.
- Backspreads and ratio spreads are referred to in terms of the smallest ratios, e.g. a 1-2 bull call spread.
- A call backspread can be used to express a mostly bullish long-volatility view.
- it has a higher breakeven and lower profit potential than a long call, but will profit if the underlying falls significantly.
- maximum loss occurs if the stock closes at the high strike
- A put backspread can be used to express a mostly bearish long-volatility view:
- unlike call backspreads, they have a limited upside potential because the stock can only go to zero
- this strategy should be compared with a long straddle. The choice will depend on the relative strengths of the bearish view and the long-vol view.
- Ratio spreads can be used to express mostly neutral views (with some directionality).
- A ratio call spread has unlimited loss on the upside, a small profit if there is a large decline, and maximal profit if the stock stays where it is (at the short call strike).
- A ratio put spread has a similar profile to the ratio call spread, but downside is limited.
Time spreads (a.k.a calendar spreads)
- Because time decay accelerates towards expiration, this is a time at which many traders may want to be short the option (capturing theta). However, writing options carries substantial risk. Time spreads, which involve buying a long-term option and selling a short-term option (same strikes), are designed capture theta while having limited risk.
- For a time spread to be profitable, the underlying should remain in a narrow range within the life of the short-term option.
- Establishing a time spread requires a debit, which is the maximum loss of the position.
- The value (at the expiry of the ST option) is depicted below:
- curved because there is still time until the LT option expires
- asymmetric because ITM calls have greater theta than OTM calls.
- If the difference in expiries is long, we have the opportunity to roll the short-term expirations, increasing the overall credit.
- ATM time spreads are neutral, but OTM time spreads can be used to create directional positions.
- the spread should be established at the target price, with the ST expiry at the expected tenor
- at ST expiry, we can decide if we want to hold the long option or liquidate, though the long option will experience rapid theta decay.
- this trade is exposed to changes in IV.