Pimp My Trade

Options Trading Cheat Sheet

Posted on February 11, 2009 by Adam

Basic Definitions and Principles

• An Option is a contract between the buyer and the seller that gives the buyer the right, but not obligation, to execute a transaction in the underlying instrument
• A Call Option gives the buyer the right to purchase units of the underlying from the seller before expiration
• A Put Option gives the buyer the right to sell or short units of the underlying from the seller before expiration
• The buyer of a call option is bullish on the underlying, the seller is bearish
• They buyer of a put option is bearish on the undelrying, the seller is bullish

• Options are cheaper than buying stock
• Options are leveraged assets - they move more than the stock

Pricing Terminology and Considerations

• Intrinsic Value = | Stock Price - Strike Price |
• Extrinsic (Time) Value = Option Premium - Intrinsic Value
• Out of the money (OTM) options have zero intrinsic value
• In the money (ITM) options are mostly intrinsic value
• ATM = At the Money
• Delta is a function of intrinsic value, more intrinsic value means higher delta
• 0 < Delta < 1
• Greater delta means greater leverage
• Option Premium Movement = Delta * Stock Price Movement
• Over time, extrinsic value erodes. This is known as time decay.
• If an option expires OTM, it has no value, since its entire premium was time value.

Option Selection Considerations

• Only trade liquid options
• Look for open interest > 1000 and tight spreads, < 5% of the premium
• Don’t be too aggressive, OTM options are more likely to end up in a loss
• Make sure you buy enough time value so that the stock has time to make its move, but don’t go too far out
• Stick to buying options until you know what you’re doing
• Always manage risk, trading options can inflate your losses too. Remember to use stop loss orders.