A Quick Primer on Trading Options
The popularity of trading options has continued to boom in recent years, with more and more individual traders looking to take advantage of the gains options trading can offer without having to risk nearly as much capital as with other securities.
The Connors Research team has developed a strategy designed to better control the risk inherent in options trading based around the ConnorsRSI indicator. As a starting point for traders who’d like to use a quantified, back-tested strategy for trading options, we’d like to share the 1st chapter from our options strategy guidebook.
Excerpted from Options Trading with ConnorsRSI:
Option trading was once the realm of professional money managers looking for efficient mechanisms to hedge their portfolios. Over the past decade, however, millions of retail investors have pushed options into the mainstream. In response to this demand, online brokerages have integrated options into their trading platforms, so that entering, tracking and exiting option positions is just as straightforward as performing those operations for equities.
One reason for the popularity of options is the wide variety of purposes for which they can be used, including:
- Hedging against losses
- Income generation via credit spreads or covered call writing
- Highly leveraged speculation
- Proxies for buying or shorting equities (stocks and ETFs)
In this Guidebook, we will focus on the final item in the list above: using options as a proxy for buying equities, specifically the SPDR S&P 500 ETF which is commonly referred to by its ticker symbol, SPY. In this context, the single biggest advantage of using options is that it allows us to capture the gains from a price change in the underlying security (SPY) while risking considerably less capital. Furthermore, as you will see later in the book, we apply a systematic, quantified approach to selecting which options to trade as well as to the timing of our entries and exits. Well-defined strategies such as the one you’ll learn here are scarce in the options industry, which is a major contributor to options’ reputation as “risky” investments among many retail traders.
Before we go on, it will be helpful to review a few terms and concepts related to options.
The owner of a call option has the right, but not the obligation, to purchase the underlying security (stock or ETF) at the strike price on or before the expiration date of the option contract. The value of a call option generally rises as the price of the underlying security rises. A call option is considered to be In The Money (ITM) when its strike price is below the price of the underlying security, and Out of The Money (OTM) when its strike price is above the price of the underlying security. For example, if the increment between strike prices for SPY options is $1 and the price of SPY is currently $142.35, then the first (closest) ITM call option is the one with a strike price of $142. The first OTM call option is the $143 strike.
The owner of a put option has the right, but not the obligation, to sell the underlying security (stock or ETF) at the strike price on or before the expiration date. The value of a put option usually rises as the price of the underlying security falls. A put option is considered to be In The Money (ITM) when its strike price is above the price of the underlying security, and Out of The Money (OTM) when its strike price is below the price of the underlying security. If the price of SPY is currently $136.55, then the first (closest) ITM put option is the $137 strike, and the first OTM put option is the $136 strike.
Most option contracts control 100 shares of the underlying stock or ETF. However, the price quoted by most trading platforms is the price per share. Therefore, the cost of purchasing the option contract is typically 100 times the per-share price, plus commissions. Thus, if a SPY call option has a quoted price of $1.27, then it will cost you $127.00 plus commissions to purchase the call option contract. Sometimes you will hear the price of an option referred to as the option’s premium.
All option contracts have an expiration date, after which the contract is no longer valid. The three most common types of option expirations are:
- Weekly: Contract expires on the last trading day of the week, typically a Friday.
- Monthly: Contract expires on the Saturday following the third Friday of the month, which means that the last day for trading the option is the third Friday.
- Quarterly: Contract expires on the last trading day of the calendar quarter.
We will be focused entirely on option contracts with monthly expirations. The monthly contract with the nearest expiration date is known as the front month. For example, if today is June 10th, then the front month contract is the one which expires in the third week of June. The next available expiration (in this case July), is known as the second month. The day after June expiration, July would become the front month and August would become the second month.
End of Excerpt