Michael Martin is Vice President of Market Strategy at TradingBlock, a provider of custom trading technology solutions.
Options trading has exploded in popularity over the past several years, and there are no signs of slowing down. More than 1.2 billion options contracts were executed in the U.S. in March alone, an increase of more than 30% over the previous year, according to the Options Clearing Corporation (OCC), a Chicago-based equity derivatives clearing organization.
However, as the number of contracts rises and the throng of new retail traders speculating with options grows, so does the failure to understand the risks involved.
Retail traders often chase leveraged returns with options, only to learn too late that pricing and risk aren’t as linear as equities. These examples not only reflect bad investor habits, such as emotional decision making and risk-prone trading, but also underscore a widespread lack of understanding of options strategies, how options pricing works and how to properly utilize them.
Engaged investors and options-curious traders who want to learn how to leverage derivatives effectively need more education. As an options broker for more than 15 years, here are a few key things I recommend traders bone up on at the outset of their options education journey.
Know the Greeks.
The five essential options Greeks—Delta, Gamma, Theta, Vega and Rho—are risk management tools that measure an option’s sensitivity to various factors, from price changes to the passage of time. They provide a way to see what may happen with an option given certain variables.
For example, Theta quantifies time decay—the erosion of an option’s value as it nears expiration—and shows how much value an option loses daily. Not understanding this Greek is why many long option traders lose money.
Delta, perhaps the most important of the Greeks, shows how much an option’s price may change relative to a $1 change in the price of the underlying asset. Delta also gives us a ballpark range that an option has of expiring in the money, giving it value. For example, if you bought a 55 call option with a delta of 0.10, there’s roughly a 10% chance it expires in the money.
Knowing all the Greeks is critical for effectively trading options because they help traders understand how various market conditions will impact the price of the option, empowering them to make more informed decisions. Without the Greeks, options trading can become a guessing game.
Know implied volatility.
Implied volatility (IV) is another essential concept in options trading and reflects the market’s expectation of future price movement, not actual movement. Traders can use the Greek Vega to measure and better understand how much IV can impact an option’s value.
A higher IV means the market expects bigger swings and more uncertainty, which would result in higher option premiums (even if the stock price holds steady), while a lower IV signifies that the market expects calm and more stability.
Understanding how IV works is crucial because it affects what a trader will pay or receive for an option, and having this insight will empower them to spot overpriced or underpriced products.
Know your assignment risk.
Options traders must be aware that short calls and puts expose them to something called early assignment risk, which is the chance that they will be forced to buy or sell the stock before the option expires. This can have significant financial consequences. If a short put option is assigned, a trader will end up with 100 long shares of stock in their trading account the following day. Conversely, if a short call option is assigned, they’ll receive 100 short shares of stock.
Assignment risk increases as expiration approaches and the option moves deeper in the money. The more in the money the option is—and the closer it is to expiration—the higher the likelihood that it will be assigned.
Traders should know that short calls are also exposed to dividend risk. As what’s called the ex-dividend date approaches, in-the-money calls are more likely to be assigned. The call buyer will likely exercise early to capture the dividend, leaving the call seller with short shares and no dividend payment.
Know thyself.
While learning about effectively utilizing options, it’s also extremely valuable for traders to consider their own attitudes and behaviors.
They should evaluate how much they want to be engaged in the market. If they are committed to only cursory engagement, then options probably aren’t right for them. Successful options traders are regularly engaged in the market and want to get under the hood to explore the ins and outs of these sophisticated products.
It’s also important for a trader to understand their risk profile, which helps define the level of risk they are willing to take to reach their goals as an investor. Factors like how much market volatility or loss they are comfortable with, their time horizon and experience all play a role in forming this critical piece of the investment puzzle.
Options traders should consider their psychological biases and ability to control their emotions because, as soon as emotions get involved in any type of trading scenario, things quickly go awry. Traders with strong track records keep their emotions in check and lean on systematic and strategic approaches.
As options grow in popularity, it becomes increasingly important for traders to arm themselves with the right knowledge—not only about options but also about themselves. And while they ought to be wary of the get-rich-quick methods promulgated by social media influencers and the overhyped products that pepper financial newsletters, traders should tap into options resources built by industry veterans and made freely available on the internet. From growing video libraries and in-depth blogs to virtual trading and options calculators, these tools can help them develop a deeper understanding of this risky derivative and how to unlock its potential.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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