Options Trading Level 1: Basic Option Characteristics

CALLS

House value/Strike price = $200.000

Option’s value/Option’s premium = $10.000. It’s the price to buy the “financial contract” that
will give me the right to buy the house for $200.000 in the future.

- Option’s price = price without the x100 multiplier.

- Option’s value/Option’s premium/Option’s cost = price with the x100 multiplier (cost
of purchasing 1 contract)

Option expiration = 2 years.

Two things can happen:

 In 1 year the house is valued $350.000. At this point I can “exercise” my option
meaning that I can take advantage of using my right to buy the house at the strike
price of $200.000.

Purchase price = $200.000.

Asset value = $350.000.
Profit = 350.000-200.000= $150.000.
Net profit = $150.000-$10.000= $140.000.

 In 1 year the house is valued $150.000. At this point I don’t have any benefit exercising
my right to buy the house at the strike price of $200.000 because I would lose money.
I could just buy the house at the current market price of $150.000. Because of that,
the option that I paid is worthless, meaning that I have lost the $10.000 that I invested
into it.

If we compare this to the loss I would have had if I purchased the house initially
without buying an option, I would have paid $200.000 for the house and because now
its value is $150.000, I would have lost $50.000, as opposed to the $10.000 that I lost
in my option premium example.

With options you have limited risk and immense upside potential. That’s why traders love to
buy options.
The reason a trader would pay so much for a Tesla call option is because Tesla shares are
incredibly volatile and can move around hundreds of dollars in just a few days’ time.

When you trade options, you will almost NEVER exercise an option. You don’t have to exercise
an option to realize a profit (as described in the Tesla example).

You need to understand that an option’s value comes from its ability to trade shares of stock
at the strike price as opposed to the current stock price.

An option’s price will ALWAYS include the benefit/profit that it can provide the owner if they
were to exercise the option.

- TSLA Call Strike Price: $800

- TSLA Stock Price: $1000
The call option’s price must be worth $200, or have a premium of $20.000 since it can give me
a $200 profit-per-share on 100 shares.

In reality, you wouldn’t exercise the call option; you would simply sell the CALL OPTION at the
higher price and your profit would be the difference between your purchase price and your
sale price.

When trading options, the goal is to profit from a price change in the OPTION, NOT TO
EXERCISE the option to buy/sell shares. Very rarely you will actually want to exercise the
action because the benefit or the profit that you can make by exercising the option will be
EMBEDDED in the options price. You can simply close the option position.

You don’t have to hold options to expiration. They can be closed whenever you want before
they expire.
The day after TSLA shares were at $811, its stock price was actually higher with an increase to
$836.

If I purchased that call option just the other day for the price of $8170 and held it until today
which the stock’s price has increased $25, now my call option is worth $9410. Now I can go
ahead and SELL the call option and my profit would be $1240.

1240/8170 = 15% return BUT the stock increased only a 3% (836/811).

**The call option price increases as the stock price increases, as the ability to buy shares at the
strike price can produce greater returns. Call options provide leverage returns.

**You don’t have to exercise a call option to realize profits. The call’s price will include any
profit you could make by exercising it. To realize a profit simply sell the call option. If you look
at any call option and compare the difference between the stock price and the strike price, the
call option’s price will be AT LEAST that amount, because it’s a law in options trading that all
option prices must include the benefit that they can provide the owner at that moment.
Let’s say a trader thought that the upward trend would continue so they bought the May 380
Call Option. The call option’s price fell as the stock’s price fell too. Finally the 380 Call Option
was worth a couple pennies or worthless since the option only had 1 day left until expiration
with a stock price of $355.

There is no value in having this options contract that gives you the right to buy shares at a
higher price than the actual stock price. You could just buy the shares at the current stock
price.

If I held this option through the expiration date and the stock price was below $380, I wouldn’t
have to do anything as the option would disappear from my account as it would expire
worthless and I would be left with the full loss of $192 on this trade.

PUTS

- Put option price increase as the stock price decreases, and vice versa.
- A put option can be used by the owner to sell 100 shares of stock at the put option’s
strike price between now and expiration.
- As the stock price decreases, this ability becomes extremely valuable.
- The option contract multiplier for puts is also 100, as for calls.
- Option’s price = price without the x100 multiplier.
 - Option’s value/Option’s premium = price with the x100 multiplier (cost of purchasing
1 contract)

Why is this put valuable when the stock price is $130.71 and the strike price is $130? We will
discuss this when we learn about option pricing in the next session.
A few days later I took another screenshot of IWM and this time the stock has fallen
significantly since the previous image.

The put option’s value increased because the share price of IWM fell. Since the share price of
IWM went from $130.71 to $122.72, the stock price is now significantly below the put option’s
strike price of $130. Now that this option can actually provide a benefit to the buyer of that
option, meaning that if I bought this option a couple of days ago for $624 in premium and now
the stock price is way below the strike price, I could use my put option to sell shares of stock at
$130 which is immensely valuable because the stock price us currently at $122.72.

Remember that you never have to exercise an option to realize the profits. We can see that is
the case because the option is this example with the lower stock price is $11.30

If I had purchased this put option on Day 1 for $624 and I held it until Day 2 where it was worth
$1130, if I sold this put option I would secure a profit of $506 on a $624 initial trade cost. My
return on that trade is 81%. But if we look at the percentage change in the shares of IWM, we
can see it is -6.1%.

Again, when you but put options, you have leverage.

If you buy put option and the stock price increases, you will lose money.

If I bought that 130 Put Option for $624 in premium and at the time of June expiration IWM
stock price was at $135, the option’s value would be worthless since I don’t need to sell shares
of stock at the strike price of $130 when I can just sell shares of stock at the current market
price which is $135.
Let’s say a trader thought that the downside would continue so they bought the May 280 Put
Option. The put option’s price decreased as the stock’s price increased. At May 1st the May
280 Put Option was trading for $11 meaning that I would have to pay $1100 Premium to buy
one these put options at the strike price of $280. This put option had about 2 weeks to
expiration at the time of entering this trade.

Unfortunately that trader would have lost everything that they put into that trade because
after May 1st the stock price ended up surging higher and therefore the put option’s price
collapsed.

There is no value in having this options contract that gives you the right to sell shares at a
lower price than the actual stock price. You could just sell the shares at the current stock price.

In the most recent date NVIDIA’s stock price was at around $321 which was above the $280
strike price. On the last bar seen in the option chart the option only had 1 day left until
expiration and with the stock price over $40 above the put option’s strike price, the option is
basically expire worthless. The stock price would need to fall over $40 for this put option to
gain actual value or benefit by the time it expires in 1 day. Since it’s such a low probability of
that happening, this put options value was trading for 1 or 2 pennies ($0.01 or $0.02), meaning
that it was essentially worthless.

If I held this option until the expiration date when the stock price was $321, I wouldn’t have to
do anything as the option would disappear from my account as it would expire worthless and I
would be left with the full loss of $1100 on this trade.
While you can make a 100% return on the trade cost, you can lose a 100% of what you payed
for those options.

Huge benefit of buying Puts

Since you have limited risk when buying put options, doing so it is far safer than shorting 100
shares of stock.

When shorting stocks, you have theoretically unlimited risk, but you make money when the
share price falls. Therefore, buying puts to make money when the share price falls with
limited risk if the share price rises is much safer than shorting stock.

Options Trading Level 2: Option Price Components

There are 2 components that make up the whole of every options price:

- Intrinsic Value
- Extrinsic Value

In my house example with the call option:

- Strike price: $200.000

- House price: $350.000

Since I could buy the house for $150.000 less than its current value (a $150.000 benefit/profit
to me), the call is said to have $150.000 of intrinsic value. The option contract is worth at
least $150.000 because me as the owner of that option I could use that option to buy the
house for a $150.000 lower than the current market price of $350.000.

The opposite is for a put option.

In TSLA call option example where I purchased the 800 Call Option and the stock price goes to
$1000. Since that call option has the ability to purchase shares of stock $200 below the current
stock price, in that instance the call option has $200 on intrinsic value.

I also told you that an options price must be worth the benefit that it can provide the owner
at that moment, meaning that it must be worth at least the amount of its intrinsic value.
That is the minimum that the contract should be worth.

I personally could use that call option to make a $200 gain on the shares if I exercise the
option, but I don’t want the option, and I’m not going to sell it to somebody else for any less
than $200 because if I use it myself, the benefit to me could be $200 gain per share. If I want
to sell it to somebody else it’s going to be worth at least that amount or more.

The June 800 Call Option has $36.41 of intrinsic value. The call’s price is $94.10 though, well
above its intrinsic value.

An extrinsic value is the portion of the option’s price that exceeds its intrinsic value. Extrinsic
value is sometimes called “time value”. We can understand an option’s extrinsic/time value
as the part of it price associated with the potential for the option to become more valuable
before it reaches expiration.
In this case there are over 30 days left until expiration but right now the intrinsic value is
$36.61 and since the option’s price is currently $94.10, the additional $57.69 is extrinsic or
time value.

TSLA shares a very volatile and since this option has a lot of time until expiration, there’s a lot
of time left for TSLA shares to move around a lot.

Just because it only has $36.41 of intrinsic value right now, there’s the potential that the
option will have significantly more intrinsic value in the future if TSLA shares increase in price,
which is certainly possible considering that TSLA can more around hundreds of dollars in just a
few days’ time. That explains why this option has a lot of extrinsic/time value in its price.

You can think of an option’s extrinsic value as the potential for that option to become
significantly more valuable through share price movements between now and expiration.

Options with MORE TIME until expiration will trade with significantly MORE extrinsic/time
value compared to the same exact option with LESS TIME until expiration.

Now the IWM put that we looked at earlier it should make complete sense why it was worth
$624 (premium) when the strike price of the put was $130 and the stock price was actually
above $130, specifically it was $130.71. The reason why the put option was worth $624 is
because it had over 30 days to expiration and with that time period, especially right now with
the coronavirus pandemic and the market volatility that we are seeing, there is certainly a
good possibility that IWM’s price falls significantly. For that reason the 130 Put Option would
become significantly intrinsically valuable, and that’s exactly what we saw happen.
So the reason that the put option was valuable even though it didn’t have any intrinsic value
is because it still had lots of time left and since the strike price was close to the stock price,
any downside movement in the stock price would leave the option intrinsically valuable which
is what happened.

If an option doesn’t have any intrinsic value it DOESN’T MEAN that the option isn’t worth
anything; if it has lots of time left until expiration then there’s still a lot of time left for the
stock price to move and that could leave the option with intrinsic value or real value.

As we saw in our call option and put option examples, if an option doesn’t have any intrinsic
value but also doesn’t have a lot of time until it expires, then there’s very little time for that
option to become intrinsically value.
Since the stock price of $304.92 is below the strike price of $305, this call options have 100%
extrinsic value. These options don’t have any intrinsic value because stock price < strike price.
They are entirely associated with the time left until expiration and for the possibility that
Apple’s price can increase between those specific time periods.

If we compare the 305 Call Option that has 1 day until expiration to the 305 Call Option that
has 246 days until expiration, we can see the call option with 246 days is x10 times more
expensive than the call option with 1 day. That’s because with 245 more days until expiration
there’s a greater potential value in the option with more time left.

The reason that a longer-term option will trade with more extrinsic value or time value is
because there’s a lot more time left for the stock price to move and because of that there’s a
lot more time left for the option to become intrinsically value.

If I buy the Call Option with 246 days until expiration for $3400 that is 100% extrinsic value and
I hold it until it has 1 day left until expiration with the Apple’s stock price still at $304.92, then
we could think that I would lose $3093 on that position simply by the passage of time. This is
called extrinsic value decay or time decay.

If an option has 10 minutes left until expiration and it has $0 of intrinsic value, there’s a good
chance that in the next 10 minutes the option is not going to be worth anything and because
of that it’s going to be trading with very little extrinsic value. If that same option had 10 days to
expiration, it would probably be trading with a lot more extrinsic value because there’s a lot
more time left for a stock price movement to occur that could leave the option with intrinsic
value.
In-the-money (ITM): is any option that has intrinsic value.

- ITM Call Options: Stock price > Strike price.

- ITM Put Options: Stock price < Strike price.

Ex:

- Call strike price: $800.

- Stock price: $836.
- The 800 call is ITM.

Out-of-the-money (OTM): is any option without intrinsic value. Only has extrinsic value in its
price. 100% extrinsic value.

- OTM Call Options: Stock price < Strike price.

- OTM Put Options: Stock price > Strike price.

Ex:

- Put strike price: $130.

- Stock price: $130.71.
- The 130 put is technically OTM.

At-the-money (ATM): is any option with a strike price very close to the current stock price.

Ex:

- Call/Put strike price: $150.

- Stock price: $150.13.
- The $150 strike price is said to be ATM.

Options Trading Level 3: Shorting Call Options

Thus far we’ve only talked about options from the perspective of buying them. When I buy
shares of stock I make money if the stock price increases, but that’s not the only way I can
participate in the stock market. I can also short stocks, meaning that I can sell them first
without owning them and if the share price falls I can make money on that transaction by
purchasing the shares or closing my position at a lower price.

The same thing can be made in options trading where we can bet against an option price, and
therefore we can make money when the option price decreases. This is called shorting
options. It’s done by SELLING an option that you don’t own as an opening trade and your
goal is to buy back the option or close the position at a LOWER price in the future.
If I SOLD a Call Option for $5, meaning I COLLECT $500 in premium, and later the option price
is worth $3 or has a premium of $300, I could BUY the Call Option for $300 to close the
position to get $200 profit.

In this image I have an order to short the 125 call option that is expiring in June which has 36
day until expiration. The current price of IWM is $120.59. This call option’s price is 100%
extrinsic value. It is OTM since the stock price < strike price.

When you SELL or SHORT an option, meaning you sell it as an opening trade, you DON’T PAY
the premium; you COLLECT the premium.

If I sell this call option short, I will collect $466 as a premium in my account since the option’s
price is $4.66. Just because I collect the premium it doesn’t mean it’s a profit; I have to close
the trade later for a LOWER premium to realize a profit. As the option’s price DECREASES in
value if the stock price remains below $125, my PROFIT on that position will INCREASE.

This is an INCREDIBLY RISKY STRATEGY since there’s no upper limit to how much the stock’s
price can reach when you short a stock or you bet against a stock’s price from increasing.

Since call options are tied to the stock price, meaning that if the stock price increases
significantly the call option will take on intrinsic value and become more valuable, IF THERE’S
NO UPPER LIMIT TO HOW MUCH THE STOCK’S PRICE CAN GO, THE CALL OPTION’S PRICE
ALSO HAS NO UPPER PRICE LIMIT, THEREFORE THERE’S NO LIMIT TO HOW MUCH YOU CAN
LOSE.

The limit you can profit from shorting options is the premium you COLLECT at the beginning
when you sell the call option.
Let’s look at the next picture to get an idea as to what the previous 125 call option would be
worth if the stock price were at its current level but the option only had 1 day until expiration.

Since this strategy is so risky, you have to have a margin account which means that you have
to be able to put collateral aside to enter that position. On this trading platform it’s saying that
the buying power effect will reduce my available buying power by about $2000. All that means
is that I need $2000 in available cash or option buying power that I can set aside to enter this
position.

So if I want to sell this 125 call option short and collect $466, I have to set aside $2000 in my
account to account for potential losses in this extremely risky position. It’s an expensive trade
to enter in terms of the amount of money that you will need.
On April 9th Netflix shares (left) closed at $370 per share. Just a few days later was higher
closing around $440 per share. On April 9th the June 400 call option’s price (right) closed at
$17, meaning the premium was around $1700. Let’s say I was a trader who believed that
Netflix wasn’t going to increase above $400 through the June expiration, and I thought that
Netflix would either trade sideways or even trade lower, leading to a decrease in the call
options value over that time period.

To enter this trade I would SHORT the June 400 call option for its premium of $1700. So I
collect $1700 in premium and my goal is to see Netflix shares decrease or not increase above
my strike price of $400 through the expiration date in June. Unfortunately a few days later,
Netflix shares closed at $440 and at that time the Netflix call option that I was short reached a
price of $62.50 or a premium of $6250 on that June 400 call option. At this moment the call
option had $40 of intrinsic value but since its option’s price was $62.50 the additional $22.50 is
extrinsic value or time value.

Current Profit/Loss:

- Shorted for: $1700

- Current value: $6250
- Current trade P/L: $-4550
- Number of contracts: 1

If I didn’t want to deal with any more losses and I bought back the option for $6250, I would
have lost $4550 in on just 1 contract.

I want to mention that it is possible to make money on a short call position even if the stock
price is ABOVE the strike price due to what is called the BREAKEVEN PRICE.

If I short the Netflix call option with a strike price of $400 and I sell it for $17, what price does
the stock price have to be for the option to be worth $17 or less at expiration? It’s the short
call’s strike price of $400 PLUS the option’s price that I sold it for which is $17 and that gives
me a breakeven price of $417.

Why is that the breakeven price at expiration?

Because at what price does the Netflix stock have to be for the 400 call to have intrinsic value
equal to what I sold the option for? Meaning if I sold the option for $17, at what price does the
option have $17of intrinsic value? Well it’s the strike price plus what I received for selling the
option: $400+$17=$417.
If Netflix was at $417 at the June expiration, my 400 short call option would have $17 of
intrinsic value and no more extrinsic value or time value, which means its price would be $17.
If I initially sold it for $17 I don’t have a profit or loss.

What if Netflix shares were at $405 at expiration? Then the 400 call option would have $5 of
intrinsic value and no more extrinsic value, which means I would have $12 profit on my short
call position. If I sold the 400 call option for $17 but he call option as only worth $5 at
expiration, then I have a $12 profit on the option, meaning that I actually have a $1200 profit.
So if I short the option for $1700 in premium and at expiration it only has $500 of value or
premium, then I have a $1200 profit on that position.

Options Trading Level 4: Shorting Put Options

Shorting put options is selling put options that you don’t own (as an opening trade). Because
put prices increase as the stock price decreases, and decrease as the stock price increases,
shorting put options is a bullish strategy.

When shorting puts, you make money if the stock price increases or remains above your
put’s strike price as it approaches expiration. Because in that scenario the option’s price will
be 100% extrinsic and as time passes and as an option approaches its expiration date the
extrinsic value or time value will approach zero.
On April 27th ATVI shares (left) closed at $67per share. Let’s say I was a trader who wanted to
profit from an increase in the share price of Activision but I also was not super sure that the
stock price was going to increase and I wanted to put on a position that would make money so
long as the stock price remained above a certain price. For this type of trade, shorting a put
option is perfect.

Because we are looking at the May expiration cycle and the trade entry date is April 27 th, this
put option at the time of entry will have a little over 2 weeks to expiration.

On the right side we are looking at the price changes of that May 65 put in Activision. As you
can see the put’s price closed at $1.75, meaning that if I shorted this put option I would collect
a premium of $175.

For shorting puts, the BREAKEVEN PRICE is the put’s strike price minus the price that you
receive for selling the option.

- Short Put Breakeven at expiration: Strike price – Sale price

That’s because put options have intrinsic value when the stock price is below the strike price.

$65 strike price - $1.75 sale price = $63.25 breakeven

That means that if Activision is at $63.25 at expiration my Short 65 Put Option will have $1.75
of intrinsic value and therefore, I won’t make or lose any money on this trade. That’s AT
expiration, not BEFORE expiration.
On May 1st Activision shares had fallen and the 65 Put was actually trading for $3.82 at that
moment (premium of $382). If I short a put option and collect $175 in premium but the
premium of that option increases to $382, I will have a $207 loss for every put option that I
shorted.

Fortunately, Activision shares turned around and they increased significantly in a short period
of time. As we can see, the price of the 65 put option that I shorted collapsed, and that’s
because the stock price rallied really high relative to the put strike price reaching a price of
$72.59 in the shares and with my strike price being $7 below that, at $65, and since the option
only had only a few days left until expiration, there was virtually 0% (not 0% but really low)
chance that the option would become intrinsically valuable by expiration.
Because of that, the option was trading with very little extrinsic value as we can see by looking
at the price of the put option ($0.02) on the final days that we have the data for.

Let’s say I bought back this option for $0.02, therefore a premium of $2 to close the short put
option. Since I initially shorted the put and collected $175 in premium and I later closed by
paying $2 in premium, my profit is the difference between the two, $173.

I could have just simply allowed this put to expire worthless by holding it to expiration and
therefore I would have made the full $175 profit, because if I short a put option for $175 in
premium and it expires with a value of $0, then I make the difference between those two
prices which is $175.

But as I mentioned, I would not advise holding short options through expiration because even
if it’s worth only a couple pennies, if for some reason Activision shares went from $72.59 and
they fell to $60 during that 1 day period, then my option with a strike price of $65 would be
worth $5 because it would have intrinsic value and that means the premium would be $500.
Since that’s $325 more than I shorted the option for, I would have a loss on that position. For
that reason I would recommend closing option positions before expiration.
Implied volatility

Implied volatility: is the market’s expected magnitude of a stock’s price changes in the future.
The option prices are the form the market tells us about the level or magnitude of these stock
price fluctuations.

Let’s look at 2 similarly priced stocks, because options are somewhat a function of the stock
price (a 10% move in a $100 stock is $10, but a 10% in a $1000 stock is a $100) so the option
price on 2 different priced stocks will be drastically different simply because they are different
priced stocks.

The 180 call option was trading for $7.35. Since the call option strike price is above the stock
price, we are looking at an in OTM call, which means that $7.35 price is 100% extrinsic value or
time value. Remember that options with strike prices near the stock price are referred as
ATM. But since the call option is only extrinsic value it is technically OTM as well.
The 180 call option was trading at $15.45. The extrinsic value in this call option is twice that of
the call option in Visa.

If I wanted to buy one the Visa call options I would need $735 in premium but for the same call
option in Teladoc with the same amount of time until expiration, I would need to pay $1545
for 1 contract.

Why would I need to pay more?

- We would say that Teladoc has higher implied volatility than Visa. This means
that the market is expecting larger stock price changes over the next 36 days
in Teladoc shares as compared to Visa shares.

How do we know that?

- We know that because the option prices in Teladoc are twice as expensive as
the options in Visa.

The fact that the Visa 180 call option is trading for $7.35 but the Teladoc 180 call option is
trading for $15.45, and both of these call options has the same amount of time until
expiration, this tells us that the market thinks that Teladoc shares could increase significantly
more as compared to Visa shares in the same amount of time. This is called Implied
Volatility.
Since Teladoc options are twice as expensive as the ones in Visa, we know that the market is
expecting much larger stock price fluctuations in Teladoc shares as compared to Visa.

Why would the market think this?

- To understand this let’s look at the volatility or the daily price ranges of
Teladoc shares and Visa shares over the same period of time. This can be done
by plotting the high to low stock price range (the highest price of the shares
minus the lowest price of the shares on one trading day) of both stocks every
single trading day over the past few weeks.

As we can see, the high to low range in Teladoc shares has been significantly higher on every
single trading day as compared to Visa shares. The stock price range in Teladoc on May 14th
was twice the range as the range seen in Visa shares on that same day. That is the measure of
stock price volatility.
Because the implied volatility, the option market or option buyers are willing to pay higher
premiums for Teladoc options as compared to Visa, and also option sellers or people that are
shorting options are demanding higher premiums to take the risk of shorting options on the
higher volatility stock. The options with more volatility have the potential to become
significantly intrinsically valuable before they expire.

I wanted to bring it up because when we are trading options, we can make or loss mony from
the changes in the stock price, from the passage of time (extrinsic value or time value coming
out the options) and from a change in implied volatility.

A change in implied volatility quite literally means that the option prices are changing. In this
case Teladoc’s implied volatility is higher than Visa’s because Teladoc’s call option price was
over $15 while Visa’s was $7.35.

Imagine the market learned some new news related to Visa and they expected significantly
more stock price movements from Visa in the future or through the June expiration cycle.
Let’s say that options traders started to buy up those options aggressively and because of that
increased demand, the option prices in Visa would increase, meaning the extrinsic value or
time value would increase in Visa’s options.

If we hold the stock price to the same, we are looking at 1 single trading day and Visa’s 180 call
option went from $7.35 to $15, that would be called an increased in implied volatility.
Basically the options are getting more expensive relative to the amount of time they have
until expiration and that tells us that the market is expecting greater levels of volatility.
Imagine I bought that 180 call option for $7.35 and the news came out, but the stock price
stayed the same and no time passed because we are looking at 1 trading day. If that 180 call
option went from $7.35 to $15, an increase in its price is advantageous to me and I would
profit from that since I own that call option.

Imagine I bought a call option and the stock price didn’t change but all of the sudden the
market expected significantly lower levels of volatility in the stock price moving forward. The
options prices, particularly the extrinsic value, would collapse and because of that I would lose
money because the implied volatility would decrease.

When trading options it’s important to be aware of implied volatility because some traders like
to buy options when implied volatility is really low since they think that they can money when
the implied volatility reached higher levels.

On the flip side of that, traders like to short options or sell them and bet against an increase of
their prices when implied volatility is incredibly high because if you short options when their
price is extremely expensive, meaning that there’s high implied volatility, and a few days later
the implied volatility is lower, then you will make money from a decrease in the valuation of
those options, without any change in the stock price or passage of time.

The change in option prices is what is causing the implied volatility to change. People think
that implied volatility somehow changes option prices, but that’s not true.

If I’m working out a lot and I’m living a very healthy lifestyle, my “implied volatility” or the
“insurance premium” that I have to pay for my insurance will be low, because I’m a healthy
individual and there’s not a high probability that my health will deteriorate. There are not a lot
of negative consequences or volatility expected for my health.

But if I changed my lifestyle and the next time I went to the doctor in a year I have admitted
that I’m no longer working out and I’m living a very unhealthy lifestyle, then they are going to
demand a higher premium for my insurance because now I have more risk for my health
deteriorating. We could say that is high implied volatility.

The insurance premium going from cheap to expensive is what causes the implied volatility to
increase, and vice versa.
Final Topics: More on Expiration, Exercise & Assignment, Which Stocks to Trade, Open
Liquidity, and Real Trade Demonstrations

There is a balancing act to every single trade that happens; if I buy 100 shares of stock by
exercising my call option, somebody who is short that same exact option is selected randomly
through a complex process (there could be thousands of people who are short that option that
I exercise) and that person will get assigned.

They will get assigned or obligated to fulfill the opposing share position that I just took. They
are assigned a short stock position or they sell 100 shares of stock at the strike price.

I will no longer have my option; I will have the stock position, and they will no longer have
their short call position, they will be given -100 shares or they will short/sell 100 shares of
stock at the call’s strike price. That is called assignment.

For put options, if I exercise my put option I sell 100 shares of stock at the put’s strike price
and I no longer have the option; I just have my short stock position if I didn’t have any shares,
or if I already had 100 shares and I exercised my put, I effectively sell my 100 shares at the
put’s strike price. Somebody who was short that option will get assigned.
If there’s a thousand different traders and they all have 1 contract that they were short of that
put contract and I exercise that put, one of them is selected at random and since they are
assigned and I sold 100 shares of stock at the put’s strike price, a short put trader will buy 100
shares of stock at the put’s strike price if they are assigned.

If an option is exercised by the buyer, someone who is short that option is assigned the
opposing stock position that the exercising party took on.

For buying a long call option or someone who own a call option, they exercise the option
meaning that they will buy 100 shares of stock at the call’s strike price, meaning someone will
get assigned a short stock position of shares at the call’s strike price.

For buying a long put option or someone who own a put option, they exercise the option
meaning that they will sell/short 100 shares of stock at the put’s strike price, meaning
somebody who was a short a put option will get assigned 100 shares of long stock (meaning
they will buy 100 shares of stock) at the put’s strike price. They will no longer have the option.

Any option with 1 penny or more ITM, meaning if it has intrinsic value of 1 penny or more and
it is held through expiration, those options are automatically exercised.

If you own a 105 call option and the stock price on the day of expiration closed at $105.01,
then my 105 call option will automatically get exercised and because of that I would buy 100
shares of stock for $105 per shares. A trader who was short that 105 call option and held it
through expiration, would sell short 100 shares of stock at $105 per share, or if they already
owned a 100 shares they would sell their shares of stock.
This is why recommend that you don’t holding options through expiration because if they are
ITM, meaning they have intrinsic value of $0.01 or more, those options, if held through
expiration, will automatically be exercised and for that reason you will end up with a stock
position corresponding to whatever option position you had.

The reason why options are not exercised in most cases before expiration is because they have
extrinsic value.

I own a call option with a strike price of $100, the stock price is at $105 and the call’s price is
$10. $5 of the option’s price is intrinsic and the other $5 is extrinsic. If I exercise my option, I
will essentially forfeit my option position and I will go through buying 100 shares of stock at
the strike price of $100, but since the stock price is actually $105, I’m essentially buying 100
shares of stock $5 below the stock price, which is a benefit to me of $500. I just gave up $1000
option to do that because by doing that I effectively just gave up $500, which is the extrinsic,
value for no reason.

So options that have lots of extrinsic value in their prices, which means they have lots of time
left until expiration, or they are ATM, OTM or even slightly ITM, those options will have lots of
extrinsic value and because of that they will not be exercised. Whoever exercises that option
will actually give up the extrinsic value for no reason. For that, options are rarely exercised
before expiration and therefore you should not worry about being assigned on an ITM short
option before expiration in most cases.

Which stocks to trade when trading options? Consider liquidity (Volume/Open Interest)

Not all stocks have options that you will want to trade. Most stocks that have options you
probably will not want to trade. You only want to trade options that have “deep” option
markets or have a lot of market participants and trading activity in them because by doing so
you will make it a very fluid process when entering and exiting your option positions.

If you trade options on a stock that doesn’t have very much option activity, meaning maybe
there’s only 5 option contracts being traded a day or there’s very few “open contracts” or
“open interest”, which we’ll talk about in a second, in those option contracts, then you’re
effectively trading with nobody. That’s kind of like buying concert tickets to a band nobody
wants to see. What happens if you need to sell your tickets?

You want to stick to stocks that are very active. If you stick to stocks with high stock trading
volume or stocks that people are trading very actively, and those stocks have options, most of
the time those options will also be very active or liquid as we say.

There are 2 things you can look at to see if an option market has a lot of liquidity or activity:

1- Volume (option volume). That’s the number of contracts that have traded on a
particular day. Every single expiration, option type and strike price will have its own
volume since those are all separate contracts. You want to see in the hundreds if not
thousands of volume. Volume starts at 0 every single day; so the volume early in the
trading session could be low even though the option markets could be very liquid and
active.
2- Open interest. The number of option contracts that are open or existing positions
between two parties.
These are all example products that have extremely active option markets and are very safe
products to conduct options trades in because there’s a lot of market participants, which
means the bid-ask spreads will be narrow and therefore getting and getting out of your trades
will be much easier than compared to trading options that don’t have very active markets.

Make sure you have volume and open interest, but particularly open interest in the thousands
if not the high hundreds close to a thousand when you are trading options on these stocks.

Bid/Ask Spread

It’s the difference or “spread” between the bid and the ask price.

The wider the bid-ask spread is, the more money you will lose from simply entering and
exiting that trade at the bid and the ask price. The technical term for this is “slippage”.
Typically when you are trading options you are going to want to try and fill your trades,
meaning actually execute the trades and buy or sell an option, near the mid-price but in most
cases you might not get filled on your trade at the mid-price right away and therefore you
might have to adjust your order price to a price that is slightly more unfavorable for you.

- Best practice when buying: try to buy at the mid-price or lower, and then
adjust higher.
 If I tried to buy this call for $558 and I didn’t get filled, meaning that
there was no other counterparty that wanted to sell the option for
$558, I would have to increase my purchase price to $559 or $560. The
prices will be changing in real time so it’s a bit more complicated than
that. That’s the general idea.
- Best practice when selling: try to sell at the mid-price or higher, and then
adjust lower.
 If I’m shorting/selling something, I’ll start at the mid-price and if I can’t
get filled, then I have to go to a slightly worse price for me, meaning
that I have to lower the price.

The general process when trying to fill trades is start at the mid-price and then if you can’t get
filled, meaning you route the order but that’s actually not filled, then you will have to adjust
your order price to a slightly worse price for you.

“Filled”: your order was successful and you bought/sold at your price. If you order food at the
court, your order is “filled” when you receive your food.

Volume and Open interest: these are important to look at especially if you are scouting out
options on the stock that you have never traded options on before. You want to make sure
that there is an option market or a deep option market (a lot of trading activity) on those
options.

- Share volume: the total shares traded in that stock today.

- Option volume: specific to the option type, strike price and expiration.

Typically the most amount of trading activity is going to be in what is called the front month
expiration. Since the nearest term monthly expiration cycle is June in the last example, it
would be called the front month expiration, and the following month would be called back
month expiration.

There are option expirations every single month; the 3rd Friday of each month there will be an
expiration. That is the standard monthly expiration cycle.

Lastly, on the 130 call option in the June expiration you can see that the open interest says
47800. That means that there are 47800 130 call options that are currently open between
people who own those calls and who are short those calls. Basically between a person who is
long the option, meaning they bought the option and somebody who is short the option,
meaning they sold the option.

The reason volume and open interest are extremely important is because it will make it much
easier for you to enter and exit your trades. With increased trading activity and a lot more
participants in the options and in the shares the bid-ask spreads will be narrower.

In IWM we can see the open interest is incredibly high, both in the call and put side. Generally
speaking, open interest in the thousands is a good sign. Not every stock is going to have open
interest with tens of thousands, that’s really uncommon; it’s typically in the most active
products.

In SPY (which is the S&P 500 ETF) we can see that again basically every strike price have open
interest in the high thousands. The bid-ask spreads are also pretty tight; just a few cents
difference.
In TTD the open interest is pretty thin and therefore there’s not a lot of volume. There’s just
not a lot of trading activity in these options.

If we look at the bid-ask spreads really quickly we can see that they are fairly wide. If we look
at the 300 call option in the June expiration the bid price is $23.20 and the ask price is $25.
That means that there’s a $1.80 difference between the highest bid and the lowest ask, which
multiplied by 100 is $180.

Options Greeks: measurements of expected options price changes given a change in the stock
price, given the passage of time and given a change in implied volatility. The options Greeks
will inform you of how your option position is exposed to these various effects/factors that we
discussed in this course that can influence an option’s price and therefore influence your P/L
on that position.