Options Trading - A General Meeting

Hello all and welcome back for blog post number six! Wow, this is moving fast, spring is finally upon us and we are now close to the two month mark since the launch of the Nolan's Investment Notion Blog! Today's post is going to be a fun one. Have you ever come across those finance guru ads, the ones where they're trying to sell you a course with their rented Lamborghini in the background, attempting to pitch you the next get rich quick scheme? Well, if you have, chances are that along side drop shipping, forex trading, maybe even sports betting, you might have heard the term 'options trading' come up a few times. So, the question at hand, does it work? Can you be profitable long term by trading options contracts? If yes, what even are they? How do the prices of options contracts move? What are some potential strategies you can employ when trading options? These are the types of questions that I am going to answer for you today, in this post. I will first get the icebreaker out of the way and touch on the profitability of options trading, then moving to what they actually are and how they work, and finally giving you an idea of some different strategies options traders employ, from novice to advanced level techniques. By no means will reading this post alone make you a six figure options trader, but it is a great place to start for a general introduction.

Can you consistently and reliably earn a profitable income trading options contracts? Yes. Well, kind of. The reality is I view options trading the same way I view any profession that extracts value from the market using anything other than long-term strategies, it is a high value skill. (Un)fortunately, high value skills are in kind of an "all or nothing" bracket. This means that when your learning it or even in the intermediate stages, you probably won't make much money doing it, or you might even lose a lot of money in the beginning. However, the silver lining is that once you're good at it, you're VERY good at it. Let's face it, when you think of "day trader", it is either someone making multi-six figures, travelling the world, living in Puerto Rico when not travelling, and working for 3 hours a day from their laptop to make an average person's weekly salary, or they lost their life savings giving it a try, and they're forced to head back to the pizza delivery job they thought they left in the dust. You could say the former of those two is in the top percentile of working professionals, which might make you feel down and gloomy regarding options trading, but it actually makes sense. According to The Trading Analyst, only 10% of day traders are actually profitable over the long-term, which was actually a higher percentage than I expected (Corvin, 2023). This number also includes all of those people who do treat day trading like gambling, by not doing the proper research and training prior to starting with real money. If you were to only take the people who properly prepare and educate themselves before starting their trading endeavors, that number would grow even bigger. The reason this number being slim actually does make sense is because of what being a profitable trader provides you with, compared to other professions. An uncapped salary potential, freedom of time, freedom of movement, and much more that you would have to be in the top percentile of any profession to achieve as well. Take sales for example, in order to have all those luxuries, you damn well better be in the top percentile, or else I am in the wrong industry. The moral of the story is yes, you can be a profitable options trader, however just like obtaining the same luxuries it has to offer in any other industry, you better be very good at it.

Yeah, that's cool and all, if I spend countless hours studying and practicing trading options I could make some money off of them, but what actually is an options contract? To truly become a profitable options trader, it's essential to first understand what options are and how they function within the market, so let’s break down the basics of options trading and how it works. There are two types of contracts, call contracts, and put contracts. To give you the most basic and generic descriptions; a call option gives you the right, but not the requirement, to buy a specific underlying asset (usually stock or bond), at a predetermined price (strike price), at or before a specified date (expiration date). A put option gives you the right, but not the requirement, to sell a specific underlying asset, at a predetermined price, at or before a specified date. In order to obtain one (or many) of these contracts, you must pay a 'premium' for the option, which is essentially determined by 5 option "greeks": Delta, Gamma, Theta, Vega, and Rho. However, Rho only really applies to bonds as it measures the sensitivity of the contract to a change in interest rates, and since we're gonna focus on mainly stock options, we'll leave him alone for now. Starting with Delta: it measures how much an options premium will move if the underlying stock goes up or down by $1. Gamma: measures the rate of change between an options premium and the underlying stock price, so essentially the derivative of delta. Theta: measures the options sensitivity to the passage of time, and is usually a negative number as options lose value overtime, which we will touch a bit more on in a moment. Lastly, Vega: measures an options sensitivity to implied volatility, which is how much the options premium will change from a one-point change in implied volatility. I know, I just threw a lot of information at you, and I am about to throw more, but I am trying to keep it as information dense as possible so that you can get a good general idea of how options work, that you can efficiently read over as many times as you need. The last two main ideas I feel are important for you to grasp the general idea about options are extrinsic versus intrinsic value, and buying versus writing contracts. To start understanding the two different values, you need to know what in the money (ITM), and out of the money (OTM) means. ITM means that there is intrinsic value within the contract, for example, a call contract with a strike price of $24, when the underlying stock is $25 per share. Since a single contract represents 100 shares of the underlying stock, this means that the contract is $100 in the money, since you can profit the $1 difference in buying 100 shares at $24, by exercising said contract, when the stock is worth $25. OTM would be if the same contract's strike price was $26 instead of $24; no one wants to pay $26 for something worth $25. In terms of extrinsic value, this is determined by how much time is left till expiration, and how high the implied volatility is on the underlying asset. For example, the more time till expiration, and the higher the volatility, generally means the higher the contracts premium, because there is more time (before exp.) and more of a chance (high volatility = moves up and down a lot) that your contract will be in the money, at some point before expiring. Simple enough, right... hopefully? I know, it is a lot to take in at once, there are entire university courses teaching this concept that I am trying to illustrate in 1500 words, but hopefully you're getting the big picture. Please bare with me for the last major pillar of information you need to have a pretty thorough and general understanding of options, which is the difference between buying a contract, and writing (selling) a contract. Buying calls or puts is pretty simple, and lines up exactly with the definitions explained earlier, if you buy a call you have the right, but not the obligation, to buy the underlying stock at your strike price, in exchange for a premium, which by the way is the maximum amount you can lose on an options trade. However, when it comes to writing the contracts, you are the seller, and you receive the premium initially instead of paying, pretty sweet right? Well, the catch is you are obligated to complete the contract if and only if the buyer choses to exercise. Back to that $24 strike price, $25 underlying stock, call option example from earlier, if I was the writer of that call and the buyer exercised, I would now have to sell that buyer 100 shares of stock at $24, when it is worth $25, so essentially losing $100 in stock value.

Phew, okay; calls and puts, the greeks, ITM versus OTM, intrinsic versus extrinsic value, and buying versus writing the contracts, I think we hit most of the basics today. As I am pretty ambitious and intrigued with trading options contracts, I will most definitely revisit this topic for future posts to discuss more advanced strategies in depth, like iron condor, iron butterfly, spreads, cash secured puts, covered calls, and many more. For now I will give you the basic idea of what your looking for when simply buying contracts. Essentially, when you buy a call contract you think the stock will go up, because if it does then you can buy for lower (strike price), and sell for higher (whatever the stock price rose to). For a put, you are thinking the stock will go down so you can sell for higher (strike price), when the stock price is actually lower (whatever the stock fell to). The beauty of options contacts is that you can make money trading them without ever actually touching the stock, or exercising the contracts (assuming the asset's options you are trading are liquid enough), because the prices of these contracts change every second, of every day, based off of all the information we have talked about in this post. Man, I love options contacts, and you will certainly see posts in the near future taking deep dives into specific strategies and more on these contracts, but for now I will stop obliterating your brain with financial nonsense, as I feel like this has been a good general meeting with options, what they are, how they work within the market, and a basic idea of why you would buy them. At the end of the day, these contracts were invented as insurance for big firms on large asset positions they held, for when times regarding interest rates and stock values are uncertain, but there is a real opportunity to capitalize on the market and extract some value from these things, assuming you do the proper due-diligence.

Thank you all very much for reading, I hope you learned something, and maybe even found a new hustle to inquire more about. As always, do the proper research before touching these things, as you can lose your shirt playing with them if not properly educated. Talk to you all on the next post!

Nolan Kushnir.

Citations

Corvin, T. (2023, December 21). 327 options trading statistics every trader needs to know. The Trading Analyst. https://thetradinganalyst.com/options-trading-statistics/#:~:text=Only%2010%25%20of%20traders%20make,end%20up%20in%20a%20loss.&text=There%20is%20a%2025%25%20chance,a%2075%25%20chance%20of%20profit.