While options can be used to generate a consistent stream of income, they can also be used to gain exposure to the underlying asset’s change in price. The difference in implementing these strategies simply involves taking different types of positions in an options contract. If an investor wants to generate consistent income through options, strategies involving entering into a short position (selling options) would be used as the investor immediately receives the premium paid by the buyer. A basic example of this is the covered call strategy. Speculation strategies involve entering a long position on either a call or put option. This allows the investor to gain exposure to the underlying asset’s market price during the duration of the contract. 

Buying Calls and Puts

Speculating on stock options is very similar to that of entering a long or short position on a stock. Both allow for the investor to gain exposure to the stock’s change in market price. The key difference between speculating on options and speculating on the underlying asset itself is that options allow for limited risk. The reason why options are attractive to investors is due to their asymmetric risk profile. This refers to stock options allowing for dollar-for-dollar exposure on the underlying asset’s price when the trade is profitable (unlimited upside) while also being able limit the total amount the investor will lose if the trade in not profitable. The total amount an investor will risk losing when entering a long position in either a call or put option is the premium paid by the investor to enter into the contract. The examples below show how options are used to speculate on the direction of AAPL using options. 

Bullish Example

In this case, buying options on AAPL provides an advantage in terms of risk when compared to buying AAPL stock. In the worst case that AAPL stock reaches zero, the option trade will only lose $800 (the premium paid) while buying the actual stock will result in a $17,000 loss (the original amount paid). However, buying stock instead of entering a long position on an AAPL option provides an advantage in profitability. Because a premium was paid to enter the options contract, the premium will need to be accounted for even if the price of AAPL stock goes up. In this case, the market price of AAPL would have to be greater than $178 for the investor to realize a profit. Simply buying AAPL stock would result in immediate profit as soon as price goes above $170. 

Bearish Example

In this case, the investor is speculating that AAPL stock will decline but the comparison is still similar to that of the bullish example above. Buying a put option on AAPL limits the total possible loss to the premium paid, which is $800. As there is no limit to how high AAPL stock can reach, there is unlimited risk when shorting AAPL. However, shorting AAPL allows the investor to be in profit as soon as the price drops below $170. In the case of buying a put option, the premium needs to be considered when calculating profitability. As the investor paid $8 per share, the price would have to drop to $162 for the option to be profitable. 

Best Practices for Buying Calls and Puts

1. 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.
2. 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%.
3. 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!

With a strong directional view on a stock or ETF, buying calls or puts is a basic strategy to speculate on direction with limited risk. This can be used for breakouts, bounces off support or resistance levels for bullish or bearish views. Buying a call for bullish views and puts for bearish ones is a simply way to get started. Select options that are roughly 1-2 months from expiration and use strike prices that are slightly in the money (60 Delta). Be sure to exit a trade prior to expiration once your directional view on the stock or ETF is either confirmed or invalidated. A very common mistake is holding onto a call or put for too long.

Vertical Debit Spreads

Placing a trade on the direction of a stock using options typically requires purchasing a call or put option. When purchasing options, the largest headwind is erosion of the extrinsic value of an option over time. This is measured by the option’s theta. For a strategy to be profitable, one must predict both the direction and magnitude of the change correctly in order to overcome the loss due to time decay. One option strategy that allows investors to minimize both their risk and the impact of this time decay factor is a vertical debit spread. A debit spread can be compared to buying a call or put option, but with capped rewards and less risk. This is accomplished by buying an “at-the-money” (ATM) option and writing an “out-of-the-money” (OTM) option. The premium received from writing the OTM option offsets the total cost of buying the ATM option, and the risk is limited to the difference between the cost of the long leg and the income received from the short leg.

Debit Spread Example - $XYZ stock is currently trading @ $100

Bull Call Spread:

This strategy compares to risking $4 with unlimited upside when buying only the 2-month $100 call option.

Bear Put Spread:

This strategy compares to risking $4 with unlimited downside when buying only the 2-month $100 put option.

‍

A vertical debit spread reduces the overall risk of the directional strategy and, furthermore, the short leg reduces the effect of time decay. Lastly, the stock does not need to move as much for the strategy to be profitable when compared to buying only a call or put option. This strategy provides three additional benefits over buying a simple call or put, while only capping rewards when the stock makes a substantial directional move.

The Optimal Debit Spread

While an optimal debit spread will depend on both one’s risk tolerance and outlook, our research has identified a few best practices for this strategy:

1. Using expiration dates that are generally more than 5-6 weeks away will reduce the time decay of the long leg.
2. Buy an option with a delta of 50-60 and write an option with a delta of 10-15. Buying an at-the-money option provides the right balance between having enough upside exposure and risking a relatively small amount of capital. And writing a 10-15 delta option provides a good balance between receiving enough premium to offset the risk of the long leg and having a strike price that is further into the future. This reduces the probability that the strategy’s profits will be capped due to a large directional move
3. Using the above parameters, the premium received from the short leg will offset roughly 10%-20% of the premium paid for the long leg.

Debit Spread Management

As with any options strategy, risk management is key when utilizing debit spreads. Once a large move is expected and a debit spread is initiated, having a planned exit strategy is important for managing both profits and losses. First, if the expected move in the underlying does not materialize, it is essential to exit the trade and cut one’s losses in order to prevent a total loss. Much like when buying calls and puts, debit spreads should generally be exited prior to expiration in order to reduce time decay. A profit target of 75%-100% of the gain on the debit spread serves as a good rule of thumb for taking at least partial profits. In addition, exiting the trade at a 50% loss will mitigate the risk of losing 100% of the premium paid. For example, if a debit spread is purchased for $1 and declines to $0.50, it is best to close the position at a loss. On the other hand, if the debit spread has risen to $1.75-$2.00, this would be an ideal time to exit the trade entirely or take at least partial profits.

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:

• 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:

Opening and Closing Options Orders 

Entering an Order

When establishing an options position, the first task is to establish a directional view on the stock or ETF – bullish, bearish or neutral. The next step is to select an option strategy, expiration date and strike price based on your directional view. Much like when entering a stock position, you can either buy or sell an option. However, on an options order you must specify whether you are opening a position or closing a position. When opening a position, a “To Open” order is used. This can either be a “Buy to Open” or a “Sell to Open” order, and each one can be placed using either a limit or market order.

Exit Strategy

Before you enter each trade, you should set yourself rules on when to exit the trade. It is important to have a sense of when to cut your losses or take your profits on any options position. When closing a position, a “To Close” order is used. This can be either a “Buy to Close” or a “Sell to Close” order, and each one can be placed using either a limit or market order.

Opening and Corresponding Closing Orders:

Example of Placing an Open Order

As this is an “open” strategy, Buy to Open is used. Most brokers will populate the above parameters when an option is selected.

Example of Placing a Closing Order

As this is a “close” strategy, Sell to Close is used. Most brokers will populate the above parameters when a position is selected.

Option Pricing and Liquidity

Options typically have wider bid/ask spreads than stocks and they vary depending on the market cap of each company. Large cap and less volatile stocks tend to have options with narrower spreads, compared to small cap and more volatile stocks that have wider spreads. Options on stocks that fall short of the top 20-30 symbols in terms of market cap tend to have narrower open interest and wider bid/ask spreads. This is important to keep in mind when placing limit orders. Pro tip: Don’t be afraid to place orders near the mid-point of the bid and ask price spread. Many orders are filled within 5-10 cents of the mid-point of the bid/ask spread.

Summary 

When entering options orders, it is important to understand the difference between buying or selling to open and buying or selling to close. Many beginners confuse this concept and end up opening an additional position instead of closing their position. Managing options orders varies depending on the strategy used, but a few common best practices should be utilized when managing losing trades - never add to a position and do not roll the trade as this could compound the risk. Profit taking should be done early if possible. Using best practices to enter and manage trades can help you maximize the effectiveness of your trades and lead to a greater probability of profit.