TMT Breakdown - Terms and Strategy
I delve into basic option terminology and for my premium members, my strategy, aka, my baby...
Welcome to The Merciless Trade Premium where we stay ahead of the changing equity landscape and trade assets that are nearing, or at, an inflection point. Today we are taking a look at common option terms and pulling back the curtain on my short-term trading strategy…
Now let’s do this…
To help clear up some confusion, I wanted to breakdown and give an explanation on many broad terms associated with option trading and how I use certain terms regarding my unique trading style. Giving my readers a better understanding of the framework I work within to trade the financial markets. Also, for my premium member’s I do a dive deep exposing how I try to trade the equity markets daily, regarding my strategies and how ideally it all works out perfectly. So, to start, I’ll explain many options terms, some of which you might already know, and a few that might be confusing. Let’s dive in.
Let’s start with the option basics:
CALL - Call options(calls) are an option contract that gives the owner of a security the right to buy a corporation’s stock at a specific price within a stated time period. Market participants purchase call options when they think a stock will appreciate in value.
PUT - Put options (puts) are a contract giving the option buyer the right, but not the obligation, to sell—or sell short—a specified amount of an underlying security at a predetermined price within a specified time frame. Market participants purchase put options when they think a stock will depreciate.
STIKE - Option Contracts are derivatives that give the holders the right but not the obligation to buy or sell an underlying security at a point in the future at a pre-specified price.
ITM - In the money - This refers to an option that has an intrinsic value if that option was to expire. An option that is in the money is an option that presents a profit opportunity because of the correlation between the strike price and the current market price of the underlying security.
OTM - Out-of-the-money options are more cheaply priced than in-the-money options because the OTM options require the underlying asset to move further in order for the value of the option (called the premium) to substantially increase. Out-of-the-money options are ones whereby the strike price is unfavorable when compared with the underlying stock’s price.
PREMIUM - An option premium is the current market price of an option contract. It is thus the income received by the seller (writer) of an option contract to another party. In-the-money option premiums are composed of two factors: intrinsic and extrinsic value. Out-of-the-money options premiums consist solely of extrinsic value.
IMPLIED VOLTILTY - Implied volatility refers to a metric that captures the market’s view of the likelihood of future changes in a securities price. Investors can use implied volatility to project future moves and supply and demand, and often employ it to price options contracts.
STANDARD DEVIATION - A statistical measurement called standard deviation shows how far specific points in a dataset are spread out from the average of that set. If data points are further away from the mean, or average, there is a higher deviation within the data set.
Greeks what are they? And not the people. 🤔
The “Greeks” are simply sensitivities of options to various factors, such as price changes, time decay, volatility, and interest rates.
DELTA: The movement of the option position relative to the movement in the underlying security(stock). The resulting number, the Delta, gives an indication of the speed at which the option position is moving relative to the underlying security or stock position.
GAMMA: Is the mathematically the second derivative of the underlying assets price, or the first derivative of Delta, and can be looked at in two ways:
As the acceleration of the option position relative to the underlying price.
Or as the odds of the change in probability of the position expiring in the money.
THETA: Theta is typically expressed as a negative number for long positions and a positive number for short positions. It can be thought of as the amount by which an option's value declines daily. An example is a theta of -0.10 indicates that the option's price will decrease by ten cents per day.
VEGA: Vega measures an option's price sensitivity to changes in the underlying securities volatility. In exact terms, Vega is the amount that an option contract's price moves to a 1% change in the underlying securities implied volatility.
RHO: Rho is the rate at which the price of a derivative changes relative to a change in the risk-free rate of interest. Rho measures the sensitivity of an option or options portfolio to a change in interest rate. Rho could also refer to the aggregated risk exposure to rate changes that exist for a book of several options positions.
The use of “certain terms” and common trades.
First, let’s look at a few common option trade structures I like to use for my strategy. One of my favorite options strategies are bull call spreads.
Bull Call Spread - This is a type of options trading strategy that involves two call options. The bull call strategy involves purchasing call options at a specific strike or exercise price while also selling the same number of calls of the same asset at a higher strike price. Also, both options should have the same expiration date, creating a vertical spread, as they go up the calendar vertically.
How does Eric use Bull Call spreads?
Spreads are one of my favorite options strategies, as they let me take advantage of the leverage options offer, while minimizing any loss of premium, or negative effects of time decay. Essentially, I use bull call spreads, but there are also bear call spreads which are exactly the same concept.
Now when implied volatility is high, and I want to hold a security for days, or even weeks. I will look to sell a spread, as I’m able to wait for a potential pivot without losing my shirt. Although selling one of the option contracts limits potential gains with the spread, the benefits significantly outweigh the costs in most of my trading scenarios.
Calendar Spread - This is an options strategy where an investor simultaneously enters a long and short position on the same underlying security but with different delivery dates.
In a basic calendar spread, you would buy a longer-term contract and go short with a near-term option with the same strike price. When two different strike prices are used for each month, it’s called a diagonal spread. We also refer to calendar spreads as horizontal spreads.
In a nutshell, a calendar spread involves a dual bet on a security’s price and volatility across different points in time. Rather than solely predicting whether an underlying asset like a stock will rise or fall, it profits from the movement of time itself.
How does Eric use calendar spreads?
These aren’t my go-to spread strategy, but when markets aren’t trending and are moving sideways, or I find a particular security could remain range bound. I often will look and think about calendar spreads. I’ll stop here for today, but I often use this spread when I change my strategy as markets lose momentum.
The reality is you won’t hear me talking about Delta, Implied Volatility, Theta, or Gamma often, but they go into every decision I make. That said, it’s important you know how I use certain terms and option structures I often trade. So, let’s go over some common terms I use.
Naked - the use of the term “naked” which is also known as an uncovered option. A seller of an option contract creates a naked option when they don’t own the underlying security needed to fulfill the potential obligation resulting from the sale. This is also known as “writing” or “shorting” an option because the seller has no protection against an adverse shift in the price of the security.
How does Eric use the term naked?
When I refer to being naked, I often mean I just own a call or put with no expectation to be excised and which has no collateral against the position, leaving it open to the effects of time decay.
Example: I have a Nov 15th $120/$130 bull call spread on AAPL. I buy back half my $130 calls expecting a move higher. I would then say that I have a $120/$130 spread and I’m naked on half with just Nov 15th $120 calls.
Legging - Legging involves establishing a spread, combination, or any other multi-leg position in options one leg at a time, rather than all at once as a single trade. Legging into a complex strategy can be advantageous to a trader if putting on the position one “leg” at a time will prove less expensive than establishing it all at once.
How does Eric use the term’ legging?
When I refer to legging, I’m usually buying a call or put intending to sell a spread in the not-so-distant future. It could be a trade that I expect if works out, i would like to hold for days to weeks. As if it’s a day trade, often I wouldn’t even consider legging in, as the effects of time decay are minimal, and I expect movement in price in the very short term.
Example: I just bought Nov 15th $120 calls on AAPL for $10 and I plan on legging into a bull call spread if the trade works out. What I’m saying here is: If we see a move higher, I would like to hold this stock multi-day and will sell a spread, legging in, in the future. While I entered the trade “naked” with just calls, I expect to leg into the bull call spread.
Rolling - Rolling options is a strategy that involves closing out an existing options position and opening a new one with different strike prices and/or expiration dates.
How does Eric use the term rolling?
When I talk about rolling, I’m expressing my desire to stay with my current trade and to move it to a different week, or month. This is a trader’s way of staying with an option trade overtime, and never taking assignment of the option contracts at expiration.
Example: I have a $120/$130 Nov 15th Apple call spread but want to hold these another month. This involves me selling my current option position and moving to a similar option position in another month like Dec 20th $120?130 call spread.
Theta burn - Also known as time decay is the act of the option losing value to the effects of time.
How does Eric use the term theta burn?
This option has some serious theta burn and I have to be very close to perfect with buying this option regarding timing the move. As if I’m wrong, I’m going to be some serious theta toast.
Gamma squeeze - is used to describe the dynamic where an option contract’s price moves sharply in one direction because of changes in the underlying security. This may happen when there is a sudden increase in demand for options contracts or if there is news that affects the securities price. A gamma squeeze is like a short squeeze in premise, but is based on the supply and demand of the option contracts and not the company’s shares.
How does Eric use the term gamma squeeze?
We have a possibility that we could see a gamma squeeze with recent option activity. If we see the stock hold around the $20 level into the end of the week, we very well could see gamma squeeze as positions get squared.