Winning in options trading is accomplished through practice, lots of practice! If you are a new (or even slightly experienced) options trader, it is important to understand that a series of small trades, where gains are banked immediately, are more valuable to you in the long-run versus a large position that has the potential to yield a large profit (or worse a large loss).
How small is small? We suggest our Options Ranker users to allocate no more than 1-3% of their buying power in a single trade.
Once you understand the basics in options trading you are ready to transition to small positions to start practicing.
1. You know what an options contract is and you understand that it derives its value from that of the underlying asset (stock or ETF in the case of equity options).
2. You also know that you hold all the cards, so to speak. When buying either a call or put, and when you sell or write a position, you are hoping on keeping the profit in the form of the premium received, provided the position remains outside of the price ranges where the buyer would profit.
3. You should know about the Greeks, particularly Theta, Delta and Gamma at least in a general sense. Theta refers to the rate of change in an option’s price as its expiration approaches. A negative Theta tells you the amount of that change in the time preceding expiration. For example, an option with a Theta of -0.10 would reduce in price 10 cents daily; a Theta of -0.50 indicates a daily price reduction of 50 cents to expiration (when the contract becomes worthless). Theta is the option seller’s friend and the option buyer’s worst enemy.
4. Gamma and Delta measures time sensitivity as well of an option’s price. This change is relative to a price movement of the stock of $1 either up or down and how that price is impacts the Delta or overall rate of change of the option’s price. Say an option has a Gamma of 0 and a Delta of 40 cents (0.40). A $1 move in either direction of the stock price means a 40 cents change in the option’s price.
However, if that same option had a Gamma of 10 cents (0.10) with the same Delta of 40 cents, the options price would only change by 10 cents in either direction, with each $1 change in the stock’s price. This means that Gamma is really a measure of the rate of change of the options Delta.
All short positions have a negative Gamma, which conflicts with the time sensitivity of an option’s Theta, as its expiration approaches. Knowing how to manage this conflict requires an astute attention to detail. It also requires more than comprehensive understanding of how the Greeks interaction impact your potential for gain or loss within a stated options trade for a given period of time. Ideally, prior to expiration.
There is a sort of an inflection point when it comes to the dynamics of gamma and delta. An option seller will start to get nervous when the gamma reaches 30+ cents and the option holder (buyer) would start to get excited at this point.
The impact of the Greeks on an options price and the ability to calculate and monitor even slight changes in these measurements can be daunting.