What is Option Trading?

So what is option trading and what can you do with options?

If there is another topic that has had more unnecessarily complicated information written about it, I don’t know what it is. Most of the usual option trading basics information can make your eyes glaze over quickly.  A lot of it is good to know, but here we will quickly get to the money making aspects.

The kind of option trading strategies we'll talk about here mainly involve selling options that are far away from where the market is trading ("out of the money").  The value, or premium, of these options will decay until options expiration. So at expiration, out of the money options are "out of time" and have no value, like this site's logo,

where "Theta" seems to be fading away. This is how we make money, selling options with the idea that they will expire worthless, or decline in value by the time we buy them back.

This is how we go about "Collecting Theta", theta being a measure of the rate of the value decline. We do this most often by trading option spreads, mostly diagonal spreads and calendar spreads at this writing.

Credit spreads and iron condors can be good trading vehicles, but the risk/reward is not as favorable. 

Back to the basics - Learning Option Trading

But let’s back up... if you need a refresher or are new to options trading, let's start by breaking down a couple of primary option trading basics.  

There are two kinds of options, a call and a put.  Basically, buying a call option is a bet that a stock will go up, buying a put is a bet that a stock will go down.  Buying puts or calls are cheaper (and leveraged) ways of buying stock.

Those seeking an answer to the question "what is option trading" soon find that there are possibly hundreds of option trading strategies that can be constructed from these two simple instruments.  But we are only concerned with a few of them.

In learning option trading, we know that the most fundamental of option trading basics consist of buying a put or a call.   You can buy a call expecting a stock to go up, or you can buy a put expecting a stock to go down in value, and if the stock does go up or down before the option expires, your call or put “might” increase in value.

The problem with buying an option instead of selling is that you have to be right on direction and timing, because of continual decay in value, otherwise known as theta decay - again, theta is the rate of time decay of value.  So, we don't buy options except when certain conditions are present, preferring to sell them instead, turning this time decay to our advantage -- collecting theta.

Instead, we sell vertical option spreads or iron condors, which we'll discuss elsewhere on the site.

More option trading basics

If you buy a December 415 Call option on Amazon, technically you have the right to buy 100 shares of Amazon at 415 before December expiration.  We don’t really care about that part of it, if the option goes up we would just sell the option, it doesn’t have to be at expiration.

Adding another dimension to the question "what is option trading", instead of buying a put or call option, you can also sell them.  You may have heard that most options expire worthless, so the thing to do is to sell them. Actually, this is even riskier than buying options which decay in value -- unless it is done the right way.  But the idea is correct, you do want to capture the time decay, but only by doing it with the least amount of risk.

An option’s value has two parts, intrinsic value, and time value.  If Amazon is at $400 and you have a $390 call the option has $10 of real value. It's called an “in the money” option because the $390 option strike price is less than the stock price, and has intrinsic value.  The option might be selling for $12 or $13, and any amount over $10 is time value (also known as premium - the part that decays over time).

This time value (theta) gradually disappears until it is at zero at expiration.  If Amazon is at $400 and you have a $405 call option, the option is “out of the money”, and whatever the option is selling for is all time value and has no intrinsic value.  Unless Amazon goes above $405 before expiration, all of this time value and will decay to zero by options expiration day.

This is not at all an exhaustive explanation on the question "what is option trading".  There is no shortage of option trading basics available in books or online when learning option trading, so feel free to seek these out if you want more information. Or, feel free to ask a question here.