EVERYTHING You Need to Know to Profitably Trade Options | Options for Beginners [2023]

so options can be a great tool for people wanting to strategically diversify their portfolios but where can you get started actually using this stuff I mean prices contracts volatility Greeks you feel overwhelmed and you really just want someone to lay out a clear road map for you to follow to take you from feeling intimidated by the markets to confident enough to make that first trade well I'm Jim Finance PhD from the University of Memphis which is one of the leading institutions in the world in the field of Market microstructure I started trading about 16 years ago and my career actually started as a finance Professor teaching both undergraduate students and graduate students so give me I don't know a couple hours and I will give you everything that you need to start trading options I'll see you inside [Music] so welcome to the options crash course 2023 my name is Jim Schultz I'm going to be your tour guide for this entire crash course and here's what I want to do let's lay out the goals and the objectives and the mission at the very beginning I'm going to assume that you don't know anything I'm going to assume that you know nothing when it comes to the world of options and over the course of the next two three I don't know man maybe four hours I want to take you from nothing to novice let's get you to somewhat self-sufficient Trader in just a few hours I want this to be your One-Stop shop for all things option trading as a beginner now what we're going to do as we move through this crash courses we're gonna break things down into distinct sections so if you want to bounce around you can easily find the different sections you can easily find the different chapters I want to make this very easy for you guys to navigate but understand that my intent how I expect you all to consume this content is sequentially from one section to the next because they are going to build on one another again starting from nothing and going all the way up to some understanding to where you feel very confident in doing what it is that you're trying to do and you know one final thing one final comment that I want to make before we dive head first into all the details inside of this options crash course I mean hey we got four hours man we got plenty of time I firmly believe that options have a place in every Investor's portfolio every single one whether you want to use options exclusively as like a 100 options portfolio you're super active that's one way that you could use options that's one way that you could use this product in your portfolio of course but some of you out there might be a little bit more conservative some of you out there might be a little bit more longer term with your focus and you have you know your passive index funds stocks that you love you kind of have that chunk of assets that's kind of the driver of your portfolio well guess what you can use options in that portfolio too so regardless of which side of the fence you might find yourself on wanting to be super active super aggressive or more conservative kind of more passive in nature I want to show you how options can fit into both of those worlds all right so without further Ado let's do it man let's dive right into the options crash course 2023 so everything that we do moving forward however many sections we get through however many hours we might go everything that we're going to do moving forward it can all be traced back to One Source concept the option contract itself this is essentially a transaction between the option buyer and the option seller all right so with that understanding as kind of our foundation here at the very beginning there's two things that I want to point out they're going to make things much much easier for you moving forward the first is this there are groups of terms that you want to understand are oftentimes used interchangeably so you kind of want to internalize these categories if you will number one buyer owner and long all mean the same thing in the concept of an option contract so buyer owner long all synonymous similarly seller writer and short are also all synonymous within the world of options so don't get tripped up if you hear these terms used interchangeably they're oftentimes pointing back to the exact same thing a seller and a short same thing a buyer and a long same thing and second and it is absolutely critical that you frame your learning and understanding in this way the option buyer the long side he buys the contract from the option seller the short side I really cannot express to you how much more seamless your learning is going to be if you visualize the transaction in that way the buyer buys the contract from the seller okay so now that we've got those few things under our belts let's now turn to the option contract itself now the contract itself has a number of standardized characteristics a number of standardized features that you know on trade entry and they do not change over the life of the option so the stock the underlying stock that's underneath the option the strike price the expiration date and the quantity these are all standardized these are all known on trade entry and they are fixed over the life of the option so let's take a closer look at each one of these guys so starting with the stock this one is pretty obvious it's the underlying stock that the option is tied to so apple or Mac Microsoft or Netflix or whatever the strike price this is effectively the transaction price that the shares will be bought or sold at should the long side of the contract choose to use or the correct term in the world of options is exercise the option we'll talk about this in more detail later on the expiration date this is the last day that you can trade that option which is the third Friday of the month for standard monthly options but it can be any Friday for weekly options and even in certain cases like with spy one of the major indexes in the whole world of the financial Marketplace you can have some intra-week expiration dates lastly the quantity standard options are always in 100 share increments so each option contract effectively gives you control over 100 shares in the underlying stock all right so those are the standardized variables that are fixed on Entry but there's still one really relevant variable left the price now this is oftentimes referred to as the cost or the premium of the option contract and this variable isn't fixed it actually floats as the market floats okay so those are some option contract Basics well now I want to turn our attention to a little bit of Market functionality whenever you go to buy or sell basically any product in the financial Marketplace you're going to be met with what is referred to as a bid ask spread differential so let's unpack what's going on with this bid ask spread differential so with the bid ask spread differential the first thing that you'll notice is you effectively have two prices associated with whatever option contract you might be looking at if we're focusing on options specifically you have an offer price or ask price the price that you can buy the option for and you also have the bid price the price that you can sell the option for standing on the other side of your order is a counterparty oftentimes referred to as a market maker or liquidity provider that is effectively the middleman that connects the buyers with the sellers what the market maker effectively does is he buys when you want to sell and he sells when you want to buy so the difference between the bid ask spread becomes a profit for him whereas it is a cost for you this is because he is effectively making a market for you to allow you the opportunity to transact in whatever option you might be interested in now an easy way to remember this the bid price and the ask price is just keep in mind that you always get the short end of the stick you have to pay more when you buy and receive less when you sell this is just a cost of doing business that is effectively the compensation for the counterparty the market maker or the liquidity provider now we'll have more to say about this later too especially when we get into liquidity specifically but right now just know that we usually try to transact somewhere between the bid price and the ask price so when we want to buy we usually try to pay a little bit below the offer price and when we want to sell we usually try to receive a little bit above the bid price oftentimes ending up somewhere around the mid price between the bid and the ask all right so that's a little bit about contract specifics and a little bit about Marketplace functionality the final piece that I want to add to our foundation that we're going to keep coming back to throughout this entire crash course is going to be the four basic option types long call short call Long put and short put every single option strategy that follows every single one the simple ones and the complicated ones they can all be formulated they're all some combination of these four basic option types long call short call Long put and short put so what I want to do now let's work through each of these guys let's unpack the directional bias let's take a look at the risk return Dynamics so that we can best understand these four individual option types remember think of all of these in terms of the option buyer buying the contract from the option seller so starting with the long call by far the easiest of the four types a long call is a bullish strategy that benefits most from the stock Rising this is essentially because long call holders have paid the short call holder for the right to buy shares in the underlying stock at the strike price before the expiration date now since the strike price is fixed over the life of the option as we just learned a few minutes ago the stock price could rise far above that strike price and this would be great for the long call holder for example let's say the strike price of the call contract was 100. if the stock Rises to 120 that's great for the long call holder because he can now buy the stock for 100 the strike when it's actually worth 120 the stock price or let's say the stock Rises to 130 even better in this situation because again the long call buys it at the strike of 100 when it's actually worth 130. so the possible return for a long call is unlimited because there's no cap to how high stocks can possibly go and as for the risk the risk is limited to the cost of the option what the buyer paid the seller this is because if the stock Falls below the strike to let's say 80 in this example the long call can just walk away from the contract he's not going to buy something for 100 the strike price when it's only worth 80. the stock price so he has the option to walk away he is not required he is not obligated to use his option if he doesn't want to and in this case he would simply be out the premium that he paid for that option okay so let's stick with the call option but now let's hop on to the other side of the fence the other side of the contract the short call essentially what's helpful to know here is that whatever the long call holder wants to do the short call holder has to honor it so if the long side wants to exercise the option I.E buy shares at the strike the short side has to honor that if the long side wants to walk away the short side cannot stop him so from a bias standpoint the short call wants the exact opposite of the long call he is bearish and wants the stock to go down and this is why options are often referred to as a zero-sum game whatever one side wins the other side loses and vice versa so going back to our example with a strike price of 100 if the stock price Rises to 120 that was great for the long call but it's going to be not so great for the short call this is because he has to sell the stock at the strike price because the longest buying at the strike price of 100 when the stock is actually worth 120. and if the stock Rises all the way to 130 it's even worse like now the short call has to sell stock at 100 that's actually worth 130. so effectively there is no cap to how much the short call could lose here which is why short options are often referred to as naked or undefined risk strategies okay but what about the return potential how does this show or call make money well it's simple if the stock stays below the strike price then the long side walks away because the option doesn't help him the short call keeps the premium he collected on entry and this is the max return for the short call remember the long side paid the premium to the short side to get the contract started on trade entry at trade origination and these scenarios for call options where the stock is above the strike and the long call benefits those are referred to as in the money options in the money call options and where the stock is below the strike and the short call benefits those would be referred to as out of the money options or out of the money call options and in the rare cases where the stock price is sitting right on the strike price those would be referred to as at the money options all right so that was a lot like I understand and can appreciate that that was a lot of information coming at you in a very short period of time so watch that a couple of times if you need to but let's complete the picture here we've got the calls situated in terms of our foundational understanding let's now turn our attention to the put side so a long put this is a bearish strategy because it actually gives the long side of the contract the right to sell stock at the strike price the long still buys the contract from the short but here he actually wants the stock price to go down as low as possible so he can sell it at that higher strike price so for example let's say the strike price in this example is 50. if the stock price Falls to 40 then the long put holder could go into the marketplace buy the stock for 40 and immediately flip it around and exercise his option to sell it for 50 at the strike price that's what a long put gives him the option to do clearly yielding a 10 profit now that's ten dollars per share and there are 100 shares per option contract so a total gain of one thousand dollars per contract okay but what if the stock falls down to 30 well that's even better for the long put holder because he can now buy the stock for 30 flip it around and sell it for 50 at the strike price and boom you have a 20 gain in this situation so what is the maximum gain well if the stock goes to zero which technically isn't unlimited but for all practical purposes when you're dealing with S P 500 stocks it is unlimited it has an unlimited feel to it at least long put holders effectively have the potential for unlimited gain okay so how does the long put lose well hopefully you're beginning to see the pattern here the long put loses if the option isn't worth anything to him so when does that happen if the stock goes above the strike so let's say it goes up to 60. the long put isn't going to sell the stock at the strike price of 50 when he can just sell it in the Open Marketplace at 60. so in that case he loses the premium he paid for it and he walks away from the contract so his loss is capped at whatever the premium was on the option all right so that brings us to our last option type the short put this is the other side of the long put contract and remember the long put wants the stock to go down so the sure put must want the opposite of that the stock to go up thus a short put is a bullish position now just like with a short call a short put has to honor whatever the long put wants to do so if the long put wants to sell at the strike the short put has to buy at the strike if the long put wants to walk away then the short put has to let him walk away but of course at this point you might be able to recognize that hey if the long put wants to walk away and on the short put I'm not going to stop him but keeping with our example if you have a 50 strike put and the stock Falls to 40 that's not good for the short put he effectively has to buy the stock at the strike of 50 the stock that the long put is going to sell to him but it's only worth 40 in the Open Marketplace so for him he has a 10 loss right the long put had a 10 gain here he has a 10 loss again you see that zero-sum game aspect kind of bubbling up to the surface here and of course if the stock Falls to 30 that's even worse now the short put has to buy stock at 50 that's only worth 30 and if the stock keeps going down and down and down it gets worse and worse and worse for the short put holder so this is why a short put is effectively an unlimited loss position even though it's capped at zero we typically think about this as an undefined risk position okay so that's the risk side to the short put well what about the return side to the shortbread how does the short put make money well now that we're in number four of four possible option types My Hope Is that you can see how the short put is going to make money if the stock rallies this is where the short put benefits the stock goes to 60 let's say the long put isn't going to use his option to sell it at 50 when he can just sell it at 60 in the open market so the long walks away the short put keeps the premium collected this is the best k a scenario for the short put holder and these scenarios for put options where the stock price is below the strike price and the long put benefits those are referred to as in the money put options and where the stock price is above the strike price and the short put benefits those are referred to as out of the money options and in the rare cases where the stock price is sitting right on top of the strike price those would be your at the money options all right so that's pretty good for our foundation I mean we just covered a ton of material in a very short period of time but I'm willing to bet that I know exactly what you're thinking right now you're thinking wait a minute Jim did I hear you right unlimited losses undefined risk no cap on how much I could lose like I'm not even going to consider that like I am out that doesn't make any sense well maybe not right now but if you hang with me throughout the rest of this crash course I might be able to change your mind starting with the very next section where we are going to begin to break down that option price into its component parts all right so now that we have a foundation of option contracts Market functionality and the four basic option types I want to dive a bit deeper into the option price itself now when it comes to option pricing there's really two different angles that you could take to this whole idea there's a theoretical angle and there's a practical Angle now over the course of the next couple of minutes I certainly want to address both but I think we should probably spend most of our time on the Practical side of things since that will get us up and running the quickest but still let's address the theoretical angle first because there are some very important elements of the theoretical understanding to option pricing that can really help us and for those of you that want to dive even deeper into theoretical option pricing I will offer up a few suggestions along the way so option prices are determined by an option pricing model and more specifically there are six inputs that are needed to compute an options price the stock price the strike price time imp applied volatility dividends and interest rates all of these are used simultaneously to determine where an option price should be set that's the theoretical Foundation now from a practical standpoint once an option contract is in the marketplace its price is largely going to be determined by supply and demand just like all prices are determined in the financial Marketplace so it's kind of like an option pricing model gets us started and then supply and demand keeps us going so an option price is really a blend of theory and practice it's really a combination of a theoretical foundation and a practical understanding but when you dig even deeper into the option price itself it always has two distinct components intrinsic value and extrinsic value now before we get into the practical application and understanding of intrinsic value and extrinsic value here is a little theoretical nugget for all of you out there all the guys and all the gals they really want to dig a bit deeper into the theoretical understanding of option pricing here's an interesting way to think about the connection between intrinsic value extrinsic value and options price and the option pricing model such as a Black Shoals option pricing model if you look at a standard application of the black shoals model for pricing a call option it effectively has two terms associated with it now don't let there being only two terms fool you this is quite possibly the most elegant piece of mathematics ever developed in the world of Finance or for those of you wanting to really dig into the theoretical aspects of the black Souls model a good place to start is to recognize the following the first term in this equation is effectively trying to measure a probabilities based value for where the stock price is today and the second term in this equation is effectively trying to measure a probabilities based value for the the strike price or the potential transaction price that we've already been introduced to today from there if you dig into this model what you'll notice is that first term is largely concerned with the intrinsic value of the option and the second term is largely concerned with the extrinsic value of the option now that's very much a blanket statement and there is certainly overlap between the two terms but that gives you a really nice starting point for wanting to learn and understand this option pricing model the black shoals model even better so there is a quick nod to the theoretical understanding of option pricing model specifically the Black Shoals option pricing model let's now move swiftly into the practical application of option pricing and let's start with intrinsic value so intrinsic value is actually really really really simple it basically just answers the following question is this option worth any thing to the long side of the contract right now in other words is this option contract in the money something we just recently learned about right now if the answer to that question is yes then the option has intrinsic value in fact it has intrinsic value exactly equal to the amount that it might be in the money if the answer is no then the option has no intrinsic value it's intrinsic value will be zero it's really that simple so for example with a 100 strike call the stock at 110 would be in the money by exactly ten dollars so it would have intrinsic value of exactly ten dollars this is a valuable situation for the long side of that call contract if the stock were at 85 however the option would be out of the money and the intrinsic value would be zero another example take an 80 strike put if the stock is 100 that put us out of the money so it does not have any value to the long put holder thus the intrinsic value is zero if however the stock price were 75 the put would now be in the money it would be in the money by exactly five dollars so it would have intrinsic value of exactly five dollars as the long put can now sell stock at 80 the strike price that is only worth 75. the stock price and just like that you now know all there it is to know about intrinsic value it's really that simple quick little warning though don't get overconfident at this point because where we're headed next into extrinsic value man it is anything but simple okay so we just learned about intrinsic value and we also know that an options price only has two parts intrinsic value and extrinsic value so if I know intrinsic value and I can somehow figure out a way to crank out extrinsic value then I will have everything I need to complete the picture for a full options price that is correct so let's dive in but before we do so let me remind you and let me reiterate it is so helpful to process all of this information thinking about things in terms of the long side of the contract buys the contract from the short side of the contract now extrinsic value is an incredibly deep and detailed metric in the financial world and it's going to take you a lifetime to really be able to appreciate and understand all the different aspects to it still however I think there are a few relationships that we can establish right here and right now that are really going to help you get started moving along that learning curve so first up the factors that impact extrinsic value this one's actually pretty simple because it happens to coincide perfectly with the variables inside of the Black Shoals option pricing model remember there were six stock price strike price time volatility dividends and interest rates these are also going to be the six factors that impact extrinsic value now from there we can actually pair down that list a bit more because when it comes to extrinsic value it specifically changes to extrinsic value on a day-by-day basis dividends and interest rates they play a role but it's pretty minor at least up against the other four variables relative to the other four variables that impact extrinsic value on a daily basis so for our purposes right here and right now we're going to take dividends we're going to take interest rates we're going to put them up on the shelf for a future project in terms of how they relate to extrinsic value so that leaves us with stock price strike price time and volatility now each of these has a very important relationship with extrinsic value so I want to work through each of them individually and I actually want to start with time because I think it's going to be the simplest one to understand so simply put more time means more extrinsic value and less time means less extrinsic value and the reason why this is the case traces back to our relationship between the option buyer and the option seller so first remember for the 12th time now the buyer buys the contract from the seller got it but second remember from our learning the four basic option types the risk we turn dynamics of option buyers and option sellers are very very different whether it's a call or a put it doesn't matter the option buyer always has limited risk with unlimited profit potential whereas the option seller has the opposite limited profit potential with unlimited risk so take these two ideas and put them together the seller is taking unlimited risk and he's selling the contract to the buyer who has the potential for unlimited gains so if the buyer wants even more time I.E a later expiration cycle with more days to expiration to try to hit those huge potential gains guess what happens to the price it goes up it goes up by way of more extrinsic value a longer period of time the short has to hold unlimited risk the greater the price he's going to charge the long to enter into that contract thus more time equals higher extrinsic value all right so that's time and its impact on extrinsic value not too bad let's now turn to the second variable that I want to look at and study its impact on extensive value volatility so much like time and extrinsic value volatility and extrinsic value also share a positive relationship when one goes up the other one goes up when one goes down the other one goes down and the reasoning is actually similar to what we saw with time so the long buys the contract from the short with unlimited potential gain and limited potential loss volatility by definition measures the potential movement of the stock so higher volatility stocks can be expected to move a lot more than lower volatility stocks as a result a higher volatility stock has a greater potential to make a large move in One Direction relative to a lower volatility stock therefore as an option buyer calls or puts it doesn't matter I would much prefer more volatility in the stocks that I have options on as that gives me a better chance at a huge move in my favor and my losses are capped anyway okay hopefully that makes sense but what about the other side of the contract what about that short side well his losses aren't capped and any gains that you make he loses so if you want an option contract from him remember you're buying it from him the short in a higher volatility stock guess what happens to the price well Center is paribus all other things being equal the price is going up by way of more extrinsic value remember the short is taking all the risk on this trade so if you're asking him to take even more risk with a higher volatility underlying stock he needs to be compensated for that risk thus higher volatility higher implied volatility to be exact which just means future estimated volatility but more on that later on the higher the extrinsic value more volatility more extrinsic value all right so that's times relationship with extrinsic value that's volatility's relationship with extrinsic value that's a lot I know so go back and review those last few minutes a few times if you need to but now I want to turn to our final relationship with extrinsic value which is going to lump the stock price and the strike price together in what I like to refer to as the proximity effect now this proximity effect which by the way is just my own term you're not going to find that on Google you're not going to find that on the internet so don't Google it because you're not going to get anywhere it's just going to lead you right back to this very video the proximity effect stock price and strike price it's obviously used to determine the intrinsic value of the option that's pretty obvious that's pretty clear we saw that just a few minutes ago but when it comes to the extrinsic value of the option it also plays a critical role and here is how to begin thinking about this now keep in mind this is a very very multi-faceted nuanced thing the proximity effect and its relationship to extrinsic value looking at an out of the money option call or put it doesn't matter the closer the stock price is to the strike price the greater the extrinsic value so if you had a stock price sitting at 50 and you were looking at out of the money calls you would see that the 52 strike has more extrinsic value than the 55 strike which has more extrinsic value than the 60 strike which has more extrinsic value than the 65 strike and so on and so forth similarly if you were looking at out of the money puts you would see that the 49 put has more extrinsic value than the 47 put which has more extrinsic value than the 45 put which has more extrinsic value than the 40 put and so on and so forth so starting with the at the money strike and moving further out of the money you will see extrinsic values drop and starting far out of the money and moving closer to at the money you will see extrinsic values rise this is effectively the proximity effect the closer the stock is to the strike the greater the extrinsic value now that's a pretty good start when it comes to the proximity effect as I've already alluded to there's a lot more going on here there's some very very special relationships around the at the money region especially when you move over to the in the money side so this is not a simple thing to understand it's actually quite complicated but for what we're trying to do right here and right now the scope of this project and this crash course is to take you from nothing to novice so I don't really want to get lost in the weeds of the finer details of the proximity effect but still we can say this the reason why we see the proximity effect behave the way that it behaves in terms of strike prices having greater extrinsic value the closer they are to the actual stock price it all traces back to the risk to the short side of the contract remember back I don't know 20 25 minutes ago when we learned how does a short get hurt on an options contract he gets hurt when the option moves in the money now I know I understand I recognize there's a lot more things happening there's so many moving Parts in terms of volatility changing in terms of time Decay a bunch of things we're going to talk about later on in future sections inside of this crash course but right now based on what we've learned what do we know shorts are hurt when an option moves in the money okay let's take that idea and let's now apply it to the proximity effect if a given strike price is closer to where the stock price is right now it obviously has a greater likelihood of moving in the money sometime soon probably so if that's the case what do you think the short on the other side of that strike is going to do to the price associated with that option he's going to increase it he's going to increase it because he's assuming more risk simply by way of a greater likelihood that that strike moves in the money now again the proximity effect and this relationship it's quite complex it's quite complicated it's quite nuanced I mean it's a central piece of the elegant piece of mathematics that is the Black Shoals option pricing model so I'm not even going to pretend that you know all there is to know about proximity effects but I do think you have a very very good understanding for being able to appreciate the relationship between stock prices strike prices and extrinsic value all right so now things are starting to come together we've got option contract specifics we've got Marketplace functionality we understand the four basic option types we understand moneyness we now have a handle on option pricing so what comes next well let me adjust my hairstyle just ever so slightly and then let's answer the question that every aspiring options Trader wants to know how do you make money trade trading options let's take a look okay so we just talked about extrinsic value and specifically the three main factors that are driving extrinsic value time volatility and the proximity effect well that is actually a perfect segue into how you actually make money with options now whether you're on the long side of the option contract or the short side of the option contract it actually doesn't matter your p l in the world of options is going to be driven by three things and three things only three things that are very closely related to what we just saw with extrinsic value but before we get into the actual drivers of option profitability let's make sure that we're all on the same page with something what is the goal of the stock market the goal of the stock market is pretty simple you buy low and you sell high like people that aren't even in the stock market know that that is the goal of the stock market well with options guess what it's the exact same thing for option buyers you want to buy the option contract as some relative low down here and then eventually sell that option contract as some relative high up here so it's the same thing you're buying low and you're selling high now with options the prices themselves are a little bit more detailed they're a little bit more intricate they're not as simple or straightforward as it might be in the stock market with the stock price because options have you know intrinsic values and extrinsic values and all those things but at the core the same goal is the same goal you want to buy low you want to sell High okay that's option buyers with option sellers it's the same thing just in reverse you start by selling high on trade entry at some relative High Point in the hopes that on trade exit when you have to buy it back it's at a lower point so you're still buying low and selling high but you're just doing it backwards so to speak you're starting by selling hopefully high and then eventually to close the position you are buying hopefully low now right now I know what many of you are thinking if you're brand new to this if this is your first foray into the world of trading in the world of options you very likely have this very question Jim how is it possible for me to sell something that I don't even own how is it possible for me to sell something on trade entry when I don't even have that something in my possession that's a great question and the answer lies in something that we've already seen in Marketplace functionality the counterparty remember we have the market maker the counterparty the person who is willing to be on the other side of our Trace where we want to buy he is standing ready to sell when we want to sell he is standing ready to buy that is the key to how we are able to sell something that we don't own so to speak how we can get into a position at trade entry by selling first and buying second because he will be on the other side of the trade so we are not required to buy first own the thing and then sell it later he will stand ready to be our counterparty if no one else will so that alone is incredibly advantageous for us as option Traders because we can do whatever we want we are 100 free to choose the side of the contract that makes the most sense to us for reasons that we're going to talk about later on in this crash course but if you want to get into an option contract and be long you can get into an option contract and be long he will take the other side if you want to get into an option contract and be short you can get into an option contract and be short he will take the other side so whether you want to buy or sell it doesn't matter remember you are free to do either there are three things that will be driving your option profitability Direction time and volatility so let's dig into each one of these starting with Direction so Direction This one is pretty straightforward if you have a bullish position on a given stock and the stock goes up you're going to make money on the directional side of the trade conversely if you're bullish and the stock goes down you're going to lose money on the directional side of the trade pretty simple your bullish strategies such as a short put or a long call they're going to make money when the stock goes up now if you have a bearish position on a given stock and the stock goes down you're going to make money on the directional side of the trade and if the stock goes up you're going to lose money on the directional side of the trade so here we'd be talking about your short calls or your long puts again fairly straightforward from a directional side of the equation okay so that's Direction and that's pretty simple and straightforward I would hope but there's still two other elements that are driving this option profitability equation there's time and there's a volatility so let's dive into time so options are often referred to as decaying assets they're decaying in that the extrinsic value that we learned about in the last section it's on a collision course with xero at expiration in other words if there is no time left there can be no extrinsic value left this is simply because once The Hourglass is empty there is no more risk to the short side of anything extra happening so he can no longer demand compensation for the risk of something happening because the time has run out and nothing else can happen so obviously as the extrinsic value is changing over the life of an option with the pressure being to the downside that is going to affect profit loss specifically because extrinsic value is affecting option pricing in fact as we've learned it's one of the two components to option pricing now whether the time element is working for you or against you depends specifically on which side of the option contract you are on and we'll cover that in more detail later on but for now just know that the simple passage of time is a key driver to option profitability all right so two down one to go we've covered Direction we've covered time let's now look at volatility so as we learned in the last section on extrinsic value volatility or more specifically implied volatility has a positive relationship with extrinsic value well that relationship is very important when it comes to option profitability too this is because remember an options price only has two components intrinsic value and extrinsic value and the intrinsic value is only affected by the money-ness of the option or lack thereof so volatility is not going to affect the intrinsic value but it is going to affect the extrinsic value in the ways that we laid out in the previous section so volatility is going higher extrinsic value is going higher and that's going to affect your p l if volatility is going lower extrinsic value is going lower and that's going to affect your p l again extrinsic value must be zero at expiration but between now and then any changes to its value will affect your current p l all right so those are the three drivers of option profitability but one final note before we close out this section the market is a living and breathing thing the market is this huge part of jambalaya where all these different things are moving around and changing simultaneously so you could very easily have a trade and you will have many trades that look like this you're losing on Direction but you're actually winning on time and volatility so even though you made a wrong directional bet you actually end up with a positive p l that's very possible and it will happen to you many many times over your option trading career or maybe you nail the directional move and volatility is working in your favor but because of the way that you've positioned your strategy you are just getting absolutely crushed by time so the net result is actually in negative you know even though you nailed two of the three profitability drivers all those different scenarios can and will happen to you if given enough time in the marketplace so just remember there are three distinctly different drivers of option profitability there's direction there's time and there's volatility okay fair enough and that's a pretty good start but in this next section what I want to do I want to dive even deeper let's take an even more detailed look at what's driving option profitability by looking at some option Greeks so we just learned about option profitability that means right now it's a really good time to dig into the option Greeks because that profitability that you're gunning for it is actually controlled by the option Greeks that we're going to talk about right here and right now now a quick little mention we already have an entire crash course on the YouTube channel about option Greeks and that crash course actually covers more option Greeks than we're going to cover today and it covers them in more detail than we're going to cover today so definitely use that additional crash course as a supplement to what we're going to talk about right here and right now but what I do want to focus on right here right now are the four horsemen of option Greek so to speak Delta Theta Vega and Gamma and here is what is really cool with where we just came from with option profitability Delta is effectively Direction Theta is effectively time and Vega is effectively volatility so can you see the parallel with option profitability and what we're about to cover okay so let's begin with a deeper dive into Delta so Delta effectively has three uses and interpretations for us as Traders it measures option price changes with stock price changes it approximates probability and it substitutes as a share equivalent now we'll cover the probability angle and the share equivalent angle a bit later but right now I just want to focus on the option price changes so Delta formally measures the option price change per one dollar change in the underlying stock price and Delta is always presented in both a decimal form and whole number form in other words what that means is this when you look at an option chain and you see a Delta of 0.3 that is oftentimes also interpreted as a Delta of 30. so why do we have a difference well the technical output of Delta from the black shoals model is always in decimal form as it is showing the Delta on a per share basis so 30 cents per share but remember there are 100 shares per option contract so if you wanted the full contract Delta so to speak it would be 100 times 0.3 or 30. so in this case you could say the Delta was 0.3 or you could also say the Delta was 30 and both would be technically correct but just understand that in the trading world no one really refers to this Delta as 0.3 they would say the Delta was 30. this is something you'll want to get comfortable with quickly so you can keep up with trading content and discussions that you might engage with okay but getting back to the option price change itself if the stock moves by one dollar then the option contract is going to move by 30 cents per share or thirty dollars per contract now option prices are usually quoted on a per share basis so if you had an option price of four dollars the stock moves one dollar then the option price would be expected to change by 30 cents up to 430 or down to 370. now which way will it move well that depends on the type of option you have a call or a put and whether or not you're bullish or bearish which we're going to get into in just a little bit but for now hopefully you can see how directly Delta impacts the option p l because it is directly linked to the option price itself oh and one final thing it's important to recognize at this point that bullish positions are positive Delta and bearish positions are negative Delta now there's a lot more to Delta as it's a very very Dynamic thing and we're going to unpack a lot more of those things as this crash course progresses but right now the important thing is that you see the link between option Delta and option profitability all right so let's now dig into the next Greek that I want to cover today Theta so do you remember how we mentioned I don't know maybe 20 minutes ago that options are decaying assets and their extrinsic values must be zero at expiration well Theta is the formal metric that actually measures that decay over time it shows you just how much each day is worth in terms of Decay and similar to Delta it is presented as both a decimal and a whole number so a technical Theta of two cents as outputted from the black Souls option pricing model on a per share basis is more commonly referred to as a Theta of two when viewed from a total contract value standpoint and just like Delta no one would really refer to this Theta as 0.2 or 2 cents they would say 2. now when tied to an options price that Theta of two cents is showing you that the extrinsic value is decaying at a rate of 2 cents per day intrinsic value doesn't Decay it is purely driven by the moneyness of the option so it is always the extrinsic value only that is decaying over time so for example an option price that is a dollar fifty today can be expected to be a dollar 48 tomorrow and then a dollar 46 the next day and then a dollar 44 the day after that and so on ceterus paribus from Theta alone all right so the last thing you want to understand at this point is that Theta is either positive or negative and here the positive or negative isn't bullish or bearish like it was with Delta instead it's actually referencing the Decay specifically in other words does this option Decay help you or hurt you if it helps you your positive Theta if it hurts you you're negative Theta okay so that's a really good start to Theta let's now move into the next Greek on the list which is going to be Vega so the reality is Delta and Theta are by far and away the most important Greeks that we use on a daily basis that means when it comes to the others especially for the scope of this crash course let's get up to speed on the basics but not necessarily get bogged down in a bunch of details that might not even be that important anyway so when it comes to Vega it measures how option prices will change when implied volatility itself changes remember how we just learned that volatility and extrinsic value share a positive relationship well here we're going to see the same thing just in a more formal way when implied volatility goes up or expands then option prices will go up by way of increased extrinsic value but more formally it is actually Vega that is showing you how much they will indeed go up and when implied volatility goes down or contracts then option prices go down by way of decreased extrinsic value but again it is actually Vega that shows you how much they will indeed drop so option buyers want option prices to go higher as we've already seen so they are positive Vega because implied volatility expansion helps them and implied volatility contraction hurts them and option sellers want option prices to go lower again as we've seen so they are actually negative Vega because implied volatility contraction helps them and implied volatility expansion hurts them okay so that's a really good foundation to Vega and it's an important concept it's an important concept not because we use it every single day but because the relationship between changing volatility and changing option prices and thus p l is a very very important relationship in fact it's such an important relationship that we're going to talk about this specifically in a very different way that doesn't necessarily have to do with Vega in just a little bit so stay tuned for that that's coming on down the shoots but let's now turn our attention to the last Greek today gamma so what is gamma well Delta Theta and Vega those are all Dynamic those are all changing those are all moving as the market changes and the market moves well even more specifically and more formally those are first derivatives of the Black Shoals option pricing model gamma is actually a second derivative of the black Souls option pricing model it measures how Delta itself changes as the stock price changes so while Delta is giving you some measure of your directional exposure gamma is underneath Delta measuring how that directional exposure itself could change as the market begins to move a very simple analogy or illustration that we could use to kind of describe this point is think of a moving car the car is moving at some speed that's Delta but that speed itself could change as the car moves even more it could accelerate it could decelerate that's going to be gamma so Delta is like speed and Gamma is like acceleration now how we use gamma specifically how we measure it how we manage it how we analyze it it's actually a bit more well suited for our discussion on undefined risk which is also coming on down the shoots in maybe 45 minutes or an hour so sit tight for that it's going to be a little bit more appropriate for us to put a more detail gamma discussion in that little bucket inside of this crash course but it's good and it's important that we've already been introduced to this idea and exposed to this whole idea of gamma so that later on when we address it in more detail it should make a little bit more sense all right so we've covered option profitability we've even covered the option Greeks at least at a basic level there's probably a question that you have right now that you're waiting for the answer to Jim should I be buying options or should I be selling options well that is a very very important question so let me go iron my shirt really quick I'll be right back and we'll start to answer it alright so I had every intention of getting right into option buying and selling right here and right now for this next section but then I realized and there was one final piece to the option premium puzzle that I want to make sure that we nail down before we answer that age-old question should you be buying options or should you be selling options and that involves taking a closer look at implied volatility so as we've already seen a couple different times actually implied volatility has a direct impact on option pricing but if we actually step back and can I take more of a bird's eye view we're actually going to be able to add another Branch to that tree so volatility by definition measures the movement of something implied volatility as evidence by the word implied is going to measure the anticipated movement of something so you're looking out into the future you're trying to forecast what is going to happen to a given stock so if you take the implied volatility of whatever stock you might be looking at you're trying to measure okay what is expected to happen over the next 30 or 45 or 60 days to go that's what you want to focus on what's going to happen in the future what is the anticipated price movement well in the world of options we actually have a formal metric that captures this whole idea that measures this anticipated movement and gives us a tradable range it's called the expected move so let's take a look so to calculate the expected move you need three variables the current stock price the implied volatility and the duration of the trade once you have those in hand the expected move calculation is actually really straightforward you simply take the product of the stock price the implied volatility and the square root of the time left in the trade divided by 365. what that gives you is a plus minus anticipated range of the stock so if the the expected move output is 5 that means the stock is expected to have a range of plus or minus five dollars over the next however many days you might be looking at so 30 days 45 days 60 days whatever if the output was 12 then that would be a plus or minus 12 range and so on and so forth now of course the market is a living and breathing thing it's random and unpredictable so there is no guarantee that the stock will stay within this range it could go much higher or it could go much lower but the reason why this is the expected move is that using the properties of the normal distribution we know that we can reasonably expect the stock to indeed fall within this range two-thirds of the time or approximately 67 percent of occurrences okay so that's a good start to the expected move can you see how this might be helpful in structuring your option strategies more on that a little bit later but for right now notice the wording that we've been using imply died anticipated expect it right these are all forward-looking metrics that are trying to make some sense of what the future might hold however as is the case with most Market prognostications the market Randomness and unpredictability is so good at simply laying to waste any ideas that anyone might have about what the future does indeed hold the randomness and unpredictability are simply difficult to overcome and when it comes to implied volatility and expected move specifically the Empirical research that we've done at Tasty has uncovered an incredibly reliable result realized volatility is consistently less than implied volatility now what does that even mean well let's take a look so one of the ways that we use implied volatility is to set the expected move that we just referenced and worked through well here's something that's important to recognize once the expected move is set and then the market moves we can go in after the fact and actually calculate what the move in the market was for that time period in other words if it's March 1st today and we've calculated the expected move for the next 30 days to be plus or minus six dollars then on March 31st when those 30 days are over we can go in and record what we actually observe so let's say it was only plus or minus four dollars this would be a case where the implied volatility what was forecasted implied a move of plus or minus six dollars but the realized volatility what was actualized only produced a move that was plus or minus four dollars so in this case the realized volatility was less than the implied volatility now if the actualized move ended up being plus or minus eight dollars then the implied volatility would have less than the realized volatility which of course can happen too but on average what the empirical findings have shown is that implied volatility is consistently greater than realized volatility so the actualized moves in the market are oftentimes less than what they were anticipated to be isn't that crazy like isn't it crazy that that just consistently regularly happens it is what we need to figure out is how can we use it as option Traders so to do just that you guys remember when we looked at the option pricing model at the very beginning of this crash course and specifically the six inputs that went into that model well let's look at it again but this time let's take a slightly different angle so remember there are six variables that go into the model with the option price that we are solving for being effectively the seventh variable well if we take the option price in the market as given having been established by the supply and demand forces that we referenced earlier then the only variable left that we don't know at this time is implied volatility so even though something like a black shoals model is indeed an option pricing model we will often use it to actually calculate the implied volatility the only unobservable variable in the model okay now take this approach and pair it with the empirical finding that we just uncovered that implied volatilities are routinely higher than realized volatilities what does that mean well one thing it could mean is one of these model inputs is also consistently off it's either too high or too low so let's take a look at the inputs of the model one by one to see what we can learn again interest rates and dividends have a small impact here so we'll eliminate those from the start because they're not really going to be the big players in this model so could it be the strike price no that's set at Contract origination and fixed over the life of the trade so that's probably not going to be what we're looking for here okay what about time now there's really no dispute about how much time is left in the option contract it's either 25 days or 30 days or whatever there's really no chance that that's too high or too low okay what about the stock price well maybe but in a market that's pretty random man that would be really difficult to deal with to try to figure out is this number too high or is this number too low not to mention when you're dealing with calls and puts it's obviously going to behave very differently so that leaves us with the option price itself could this be the variable that is consistently off and if it were what would that mean well remember that implied volatilities have been shown to be consistently higher than realized volatilities and we also know from what we've learned in this very course that implied volatilities and option prices have a positive direct relationship which simply means they move together so if implied volatilities are too high relative to realize volatonies and we hypothesize that it is the option price itself that's causing implied volatilities to be too high that we can reasonably conclude that option prices themselves might be too high well that my friends is indeed our hypothesis that implied volatility is being too high relative to realize volatilities and expected moves being too wide relative to actual moves is indeed caused by and driven by option prices themselves being too high on average and that is what we intend to take advantage of how are we going to do that well remember the option contract has two sides you have the option buyer and you have the option to sell it and all the asymmetric risk return relationships that go on either side of the contract remember the buyers effectively have low risk and high return potential and the sellers effectively have high risk and low return potential so in essence option buyers are buying big movements and option sellers are selling big movements or to put it another way option buyers are basically buying implied volatility and option sellers are basically selling implied volatility but based on what we just learned one side has effectively a built-in Advantage so now we are ready to finally answer the question should you be buying options or selling options so let's do it all right so now at this point man we've got option contract specifics we've got Marketplace functionality we've got p l we've got Greeks we've got realized volatility we've got implied volatility we've got expected moves we have all these different things it's finally time to answer the question should you be buying options or selling options from our Vantage Point selling options is the way to go now does that mean that you can never buy another option again no not at all but when it comes to the core Foundation of your portfolio we feel very strongly that that needs to be built from the short side of the option contract now why do we feel that way well for starters let's go back to some of the drivers of profitability that we've already looked at Delta Theta and Vega and let's add a few new elements to the mix so starting with Delta if I buy an option I need Delta to drive my profitability so in other words I need to get the directional move correct otherwise I'm not going to make money I'm not going to make money because the other two profit drivers Theta and Vega are working against me if however I sell an option Delta's impact on profitability can help me but I don't necessarily need it to be profitable in other words when I sell options I can make money without being directionally correct that's really important and the reason why I can do that is because now Theta and Vega are working for me so remember that we learned that options are decaying assets and their extrinsic values are headed to zero at expiration so that means there is going to be this persistent downward pressure on the option price by way of this gradual drop in extrinsic value over time if nothing else changes well if I'm an option buyer that's going to hurt me that's going to hurt me because I want option prices to rise remember Buy Low and sell high so here as we've already started to see earlier this negative Theta is causing time to work against me that is not good but if I'm an option seller this is going to help me it's going to help me because I want option prices to fall remember here it's sell high and then Buy Low so here the positive Theta I have is causing time to work in my favor that's very good and lastly with volatility option buyers want volatility to expand because that pushes option prices up which again is what an option buyer wants and option sellers want volatility to contract because that pushes option prices down which is exactly what an option seller wants so who has the advantage well volatility in the market is usually in a state of contraction it's not equally weighted it's not 50 50 between expansion and contraction more than 80 percent of the time volatility is Contracting and this is largely because volatility tends to move inversely with market prices and over time the market tends to grind higher so that means that over time volatility tends to grind lower thus option sellers have an advantage here now of course this isn't to say that volatility can't expand because it certainly does and this isn't to say that if you sell options you're guaranteed to make money because of this persistent volt utility contraction that's not true either but statistically over time it does give the nod to option sellers okay so let's put this all together if I buy options I better make money from the directional side of the trade I better make money from that directional side of the trade because both time and volatility are working against me so that unlimited profit potential that I'm going after a gimme is stacked up against two pretty sizable gotchas in terms of the time and volatility dragging down my profits conversely if I choose to sell options and the unlimited risk hasn't scared me off yet a pretty formidable gotcha that I'm left with not needing to be right directionally which in itself is a pretty big gimme not to mention I have time working on my side another gimme and volatility working on my side yet another gimme so can you see why we prefer to sell options as opposed to buying options hopefully by now the advantages are pretty clear now yes there is this elephant in the room of unlimited risk I'm not going to pretend this is something that it isn't I'm not going to pretend that there won't be times when you take one upside the head and your Underoos get soiled that it's absolutely going to happen that is just the truth but by selling options specifically out of the money options we're able to position ourselves with very high probability setups just like this so when you buy a stock it's pretty simple it's a 50 50 proposition well maybe 5347 with positive drift but we'll keep it really simple the stock goes up you make money the stock goes down you lose money the stock goes nowhere you break even but if you buy options it's actually usually worse than 50 50. you might have a probability of profit or pop of 40 or 35 or whatever this is because you have to overcome the randomness and unpredictability of the market get the direction correct all while time and volatility are working against you but if you sell options again specifically out of the money options you'll have a greater than 50 50 pops so maybe 58 or 65 or 70 or maybe even higher this is because not only do you have positive Theta helping you time passing and short Vega helping you volatility Contracting you also have the buffer between where the stock price is now and the strike price that you've selected that distance is where the stock could move and the option still isn't in the money which again remember is where the short side of the option contract really gets hurt so by selling options out of the money options you put yourself into high probability situations where both time and volatility are working in your favor and you don't need to be directionally correct to us that sounds like a winning strategy and maybe it does to you too but I know there will still be a number of you out there maybe somewhere around 100 percent that are thinking Jim my brother the unlimited risk potential still can't swing it man is there anything that you can do for me on that well you my friend are in luck because in this very next section we are going to cover defined risk strategies so let's do it so in the world of options there are two different categories of strategies there is defined risk strategies and there is undefined risk strategies and in this section we're going to cover Define risk and then the next section we're going to cover undefined risk now a couple of things before we get rolling in this section there's already a crash course on the YouTube channel all about strategy management so definitely use that as a supplement to what we're going to cover right here and right now my objective in this crash course is not to cover all the details and all the gimmies and all the Godzillas associated with every single strategy that's more so what that other YouTube crash course is doing about strategy management what I want to do right here right now is I want to get you up and running I want to get you up to speed on a couple simple things that you can begin doing right away and then use that as a catalyst to continued learning but second and this is just the cold hard unfilled through truth consistency with your trading in terms of outcome in terms of profitability in terms of risk control it's going to be found primarily with undefined risk strategies I know I know it seems totally backwards and completely counter-intuitive but in my own experience and my conversations that I've had with Traders over the years thousands and thousands and thousands of conversations the one common denominator that keeps coming back across all the successful Traders and most of the successful Traders some are bulls some are bears some do this and some do that but they all share this common denominator of a strong consistent emphasis on undefined risk strategies but we'll get more into all of that in the next section in this section let's focus on Define risk strategies so Define risk strategies are effectively strategies where you're going to be able to take advantage of some of the benefits of short premium without being exposed to the potential of unlimited losses you'll have a line in the sand that you determine where you want to put it that will effectively cap your maximum loss on a given position on a given trade now that safety net that you're going to put in place that's a pretty big gimme and for every gimme there's a gotcha so what's the gotcha here well notice how just a couple of seconds ago I said that with defined risk strategies you're going to be able to tap into some of the benefits of short premium that's right to Define your risk on a given strategy you're going to have to bring long options into the mix and then you're going to have to absorb all the costs that come along with long options like negative Theta like positive Vega now because of the way that you'll structure your trades which we're going to go through here in just a little bit you're still going to be net positive Theta time working for you and that negative Vega volatility contraction working for you but it's going to be a very watered down effect it's not going to have nearly the potency or robustness of an undefined risk strategy as we will see in the very next section so to see how all of this works I want to set up two strategies here in this section a short vertical spread and a short iron Condor again use the YouTube crash course we already have out there on strategy management to supplement this material as I'm not going to be able to go into a deep dive into every strategy that's out there I want to focus on the short vertical spread and the short iron Condor so a short vertical spread this is going to be composed of two legs one short option and one long option the short option is going to be the driving force of the strategy and the long option is going to be the risk defining element of the strategy now you can choose a bullish short vertical spread or a bearish short vertical spread bullish short vertical spreads would be short put spreads just as short puts are bullish strategies bear is short vertical spreads would be short call Sprints just as short calls are bearish strategies the key with either is that the short option is always closer to the stock price that's what makes it the driving force of the strategy which ultimately gives you net positive Theta and net negative Vega this is because similar to extrinsic value being the highest at the money both Theta and Vega are highest at the money two for a given expiration cycle so because we're selling an option closer to add the money and buying an option further out of the money the Theta that we sell on the short option is larger than the Theta that we buy on the long option and the Vega that we sell on the short option is larger than the Vega that we buy on the long option now let's take all that and set up an actual vertical spread so here is a short put spread set up in iwm the Russell 2000 Equity index you can see the stock price is about 175 and the strikes for the short vertical spread are 172 and 169. the 172 is short with the S next to it because you're selling that leg and the 169 is long with the B next to it because you are buying that leg this makes you that positive Theta you can see you have about 20 cents a day and that's already 20 cents not 0.20 as a decimal and then convert it into twenty dollars the trade bar on tastyworks already converts it to a whole number for you and that positive Delta as this is a bullish trade you can't see it here but you're also net negative Vega on this trade you can also see that your probability is over 50 50 at 60 percent specifically your max profit is a hundred dollars or the credit you collected of one dollar times 100 shares in the contract this would happen if the price of the spread fell to zero remember when you sell options you want to sell high and Buy Low so here you would sell this short put spread for a dollar and if the option stayed out of the money like they are right now the value of the spread is going to slowly decrease because again we have that downward pressure being placed on the extrinsic value of the option price and fall all the way to zero at expiration if the options stay out of the money this is because the price of out of the money options is only extrinsic value because they're being out of the money means intrinsic value is zero thus the price of this spread must be zero at expiration if it's out of the money because it's only extrinsic value and extrinsic value is zero at expiration notice also that the max loss of this strategy is two hundred dollars this is found by taking the width of the spread of three dollars in this case and subtracting the credit you collected of one dollar which gives you two dollars multiplied by 100 shares in the contract giving you a maximum loss of two hundred dollars this is what I meant when I said that the long leg of the spread essentially defines your maximum loss it sets the width of the spread which in turn sets your maximum loss on the strategy so if iwm goes down here and both options move in the money then this vertical spread is going to be worth a maximum of three dollars at expiration it doesn't matter how low it goes the maximum value of the total spread is three dollars because the short put and the long put will always cancel each other out at any point above a three dollar spread value so if it comes to it the spread is in the money and you have to buy it back for let's say two dollars and fifty cents then you would lose one dollar and fifty cents or one hundred and fifty dollars total on the contract or if you bought it back for 275 let's say you would lose 1.75 or 175 dollars on the contract or if it reaches its maximum value then you buy it back for three dollars you lose two dollars or two hundred dollars on the total contract that is your worst case scenario in this example man that was a lot like I know there was a ton of information coming at you in a very short period of time but I would go back and I would re-watch those last couple of minutes on those slides a few times take some notes and really sit with that information because a lot of what we just went through in the last couple of minutes really ties together so many different things that we've been learning and building upon up until this point then what I would do is I challenge you to hop into your tastyworks platform and try to build a short call spread the other side of the market the bearish side of the market try to build that on your own see if you can use the principles and the insights and the ideas that we just laid out on the short put spread side and build for yourself a short call spite in fact I challenge you to pause the video right now and do it before you continue but what I want to do now is I want to move to our second strategy the short iron Condor and for those of you out there all my overachievers I didn't pause the video just Jim I'm just plowing through the content well you my friend are in luck because I'm about to give you the cheat code to the short call spread because it is part of the iron Condor strategy so let's take a look so an iron Condor is a neutral strategy where you're not bullish or bearish you're actually neutral and you effectively want the underlying stock to stay within a range this is because what you have with an iron Condor is a short put spread below which we just went through in a short call spread above which you just attempted on your own now same setup with each you're a little out of the money with the short option and then further out of the money with the long option the important thing here is the width is symmetrical on both sides of the iron Condor for a standard iron Condor now with the Standalone short vertical spread short put spread or short call spread we usually have to collect about one-third the width of the spread in credit and with an oil Condor it's the same thing except here it's one-third the width of the spread from both sides not from each side so like with this five dollar wide iron Condor that we've got set up in the diamonds Dia we're collecting about 94 cents from the short put spread and one dollar from the short call spread for a total of 1.94 okay so now that our iron Condor is set up what do we want to have happen well we want diamonds to stay within our short strikes because that would mean that both sides of the strategy are out of the money which is exactly what we want if possible we want both sides to remain out of the money so their prices collapse and we're able to buy them back lower than where we sold them okay easy enough but what happens if the stock doesn't stay within our short strikes well that's where our risk is this is a neutral strategy so we can effectively get hurt on either side because if the short put spread goes in the money or the short call spread goes in the money then that's not good if either of those happen then the strategy is heading towards its maximum value which is always the width of the spread or in this case five dollars if we had to buy the strategy back for five dollars then we'd be at our Max loss which you can see in this case is 306 dollars or the width of the spread five dollars less the credit we collect 1.94 so 306 times 100 100 shares per contract or three hundred and six dollars but we still have a better than 50 50 probability on the trade and we're collecting positive Theta from the start so the odds are in our favor at trade entry okay so there is a quick primer on short vertical spreads and short iron encounters and remember guys this is not intended to be an exhaustive list of all the different strategies that we use or even all the different details of a specific strategy it's more so intended to be a catalyst to get you going and get you started but now you are armed with the foundational elements of two of the most common defined risk strategies that we use every single day short vertical spreads and short iron Condors but before we dive head first into undefined risk strategies one final thing to find risk strategies are great because you have that Safety Net in place but of course you have to give up a lot in exchange for that safety net but that's not necessarily A Bad Thing This is because if you're just starting out which I assume is many of the people that are watching this content and you know digging into this crash course if you're just getting going then your primary focus should be on Define risk strategies yes I really think you're going to have more success ultimately with undefined risk strategies which is where we're going in the very next section but you can't skip this step you have to cut your teeth on defined risk strategies you have to understand how the market moves you have to make some mistakes with short vertical spreads and short iron condors and other defined risk strategies before you move on to undefined risk strategies so with all that being said let's now move on to undefined risk strategies and see what's so great about them alright so now that we've got a couple of defined risk strategies in our back pocket let's turn our attention to the next section which is going to focus on undefined risk strategies so as I mentioned just a little while ago I truly believe that it is undefined risk strategies that are going to ultimately be your pathway forward to consistency and reliability that has not changed that is still the same but naturally you might be wondering Jim how can that possibly be how can that possibly be if you have unlimited risk and you're going to have to absorb these three or four or five standard deviation moves from time to time aren't those going to set you back so significantly that they're going to negatively impact the end results that's a great question and that's an important question and I want to get to that but before we get to that let's go ahead let's set up this section the same way that we set up the previous section in the Define risk section we went through a couple of strategies that can get you up and running that can get you started let's do the same thing with undefined risk strategies let's go through two of the more popular undefined risk strategies that we use all the time and then again use that strategy management crash course that's already on the YouTube channel as a good supplement to what we're going to cover right here and right now so let us now turn our attention to our first undefined risk strategy the short put now the great thing about a short put is it is simply the undefined risk version of what we've already seen with this short put spread so let's dive in and let's take a look so a short put is about as simple as they come in terms of strategy setup there is only one leg and it is the short put so where a short put spread was a short put and a long put here you're removing the long put which makes sense because remember the long option in a short vertical was the risk defining element here we don't want a risk defining element by the nature of this being an undefined risk strategy so we remove that long leg and without having that long leg in place we don't have to water down any of the positive Theta or negative Vega that we collect from the short option so here we're much more advantageously positioned to benefit from short premium so where Define risk strategies only captured some of the benefits of short premium undefined risk strategies capture all of the benefits of your premium like right here with this short put that we have set up in GLD the ETF that tracks the spot price or current price of gold here you can see that the price of GLD is almost 169 and we have set up a short put at the 164 strike our credit collected is 1.64 and our pop is a pretty robust 74 so the first thing you should notice is that pops on undefined risk strategies are generally much higher than Define risk strategies that makes sense since you're taking on unlimited risk you have to be compensated for that unlimited risk and that is what we see here also notice that the Theta at two dollars and eighty cents is significantly higher than what we had with our short put spread which I believe was only about 20 cents or so so not only do you have higher probabilities but you have a whole lot more time Decay working for you in the form of higher positive thedas now from a Delta standpoint you're positive about 28 Delta so that means you can reasonably expect the option price to change by 28 cents for every one dollar move in GLD and another way to think about this Delta is that this position is going to feel like holding 28 long shares of GLD stock that's kind of the share equivalence that I referenced much earlier in the crash course lastly also notice that your max profit is still the credit collected so in this case 164 dollars if the option price Falls to zero but also notice that both your max loss and buying power reduction are much higher than they were with a defined risk short put spread that makes sense because you no longer have that long leg defining your risk so the max loss of Sixteen thousand dollars is indeed your maximum loss now what would need to happen for that to actually materialize well GLD would have to fall to zero or in other words gold as in the physical asset would become literally worthless is that likely to happen no it is not but that doesn't mean that GLD can't make some really big moves so that is why the buying power required to hold this position is about three thousand dollars this is a more let's call it practical measurement of what you could expect to lose in the event of an unusually large move against you so lower in this situation now just to be clear that doesn't mean you will automatically lose three thousand dollars if GLD moves lower and GLD moves against you or you couldn't lose more than three thousand dollars in some cases but it just gives you a good reference point for just how much risk you are actually taking and how large this position practically is okay so those are the basics of how how you set up a very simple short put strategy and I personally think a short put is a great beginner strategy because you have three things that are effectively working for you with a short put strategy you have positive Theta you have negative Vega and you also have positive Delta so in essence you're able to take advantage of all the things that come with options positive Theta and negative Vega but you're also playing the market to the upside you're playing the market to rise higher which is something that you're probably already familiar with with stocks and mutual funds and things of that nature but now let's turn our attention to our second strategy the short strangle and just like a short put was the undefined risk version of the short put spread a short strangle is going to be the undefined risk version of the iron Condor so let's take a look so here we have a short strangle set up in apple and the only change that we've done here from the short put is add a short call to the top side of the strategy so just like how an iron Condor is a short put spread below and a short call spread above a short strangle is a short put below and a short call above so not only are you taking advantage of positive Theta and negative Vega on one side you're actually taking advantage of positive Theta and negative Vega on both sides of the strategy therefore you'll frequently be able to generate pretty nice amounts of theta on strangles as we see here with a daily Theta of over eight dollars now the pop is also pretty nice at 74 which again is much higher than the iron Condor pop that we saw with the diamonds I believe that was around 55 or so now your Delta here is around zero as much like an iron Condor this is a neutral strategy as you simply want the stock to stay within your short strikes and not go too high or go too low the credit collected is a respectable 2.90 six cents and the buying power is about thirteen hundred dollars which again is put in place as a practical measurement of the likely risk that you would face in the event of a sizable move against you what you'll also likely notice here as you know kind of the mini elephant in the room so to speak here your max loss isn't even a huge number it's just Infinity like there is no cap to how much you could lose that's pretty scary now theoretically that is true there is no cap to how much you could lose but what does that actually mean what would need to happen for you to be headed in that direction it's not the stock falling down because the lowest it can fall to is zero and that has a defined loss associated with it so then it must be the stock rising and that is correct the reason why there is no theoretical cap to how much you can lose is because there is no theoretical cap to how high Apple could go or any stock can go for that matter now practically it would take a Monumental Catalyst just an incredible event for Apple to go up thirty dollars forty dollars or fifty dollars in the next month or two let alone doubling or tripling or getting anywhere near this infinitely large cap which isn't to say you couldn't have a big loser on your hands you absolutely could but it does give us a better sense of what Infinity actually represents in this context and there you have it there's the short strangle and a basic Foundation to understanding the short strangle so you are now armed with two undefined risk strategies the short put and the short strangle so now let's Circle back to this whole idea of undefined risk strategies offering you more consistency more predictability more reliability over time in the face of these potentially really large moves against you these potentially infinitely large moves against you how can that possibly be so well the secret lies in the unfiltered exposure that these strategies give you well as you've just seen with these undefined risk strategies you have a lot more positive Theta and presumably negative Vega working for you on a single trade now on one trade in One Singular occurrence is this going to make a big difference no it's not when compared up against a short put spread or a short call spread or an iron Condor but do this every week do this multiple times per week per month per quarter per year for multiple years and you can see how the differences are really going to accumulate over time that advantageous nature of being exposed to more time Decay being exposed to more volatility contraction it can really add up to huge amounts in the end over time but also remember how we just learned that implied volatility is consistently greater than realized volatility so in other words the actual moves in the marketplace consistently come in underneath within the expected moves that the marketplace predicted well what type of strategy can take advantage of this empirical finding short premium strategies okay let's go even further what types of short premium strategies can best take advantage of these empirical findings undefined risk short premium strategies now why is that well it's very simple with an undefined risk strategy you don't have that long leg in place that's effectively slowing you down that's effectively dragging down your positive Theta your negative Vega your overall probabilities on the trade just like we've seen in this section and the previous section now I know I recognize it's super counterintuitive it probably doesn't make sense to you right now and I don't even expect it to make sense to you right now but just file it away in your memory banks and get in the arena start making trades start putting on strategies start watching how they react to given Market movements and you are going to see sooner or later exactly what I mean okay that's all well and good right now you're probably wondering alright Jim you sold me you sold me undefined risk strategies I'm still kind of on the fence about undefined risk strategies but I'll give them a shot all right now that I've got them on now what do I do how do I manage these guys what am I looking for what am I not looking for like what do I do day to day with these strategies you know those are some really great questions and it's almost like I knew they might be coming because in the very next section that is exactly what we are going to cover okay so now you've got some strategies working for you you've got these guys on you've got these guys going that's great but now what do you do what do you do when you have a winner what do you do when you have a loser what do you do when you have something that's kind of not a winner or loser just kind of hanging out just kind of in between well that is exactly what I want to cover in this section and at the risk of beating this reference to death I do have to mention now for the 15th time in the last I don't know 35 minutes or so definitely use the strategy management crash course as a supplement to what we're going to cover right here and right now it is just going to give you a lot more depth and detail around the specific management techniques that we might employ for a given strategy or set of strategies that's beyond the scope of what I'm trying to cover in this crash course I'm really just trying to cover a broad-based overview of how we approach managing our positions in general and then give you a few things to think about to get you up and running so generally speaking our approach to the markets is actually pretty simple we manage our winners we close our winners early and then when we have a loser we try to extend the duration of that trade when we can to give it a chance to come back this is the basic idea in a nutshell behind how we approach the management of all of our strategies but a bit more specifically let's talk about three of the different categories of management that you might see us utilize here at Tasty managing winners managing losers and managing early now unless otherwise noted we will lump Define risk and undefined risk strategies in together and treat them the same and I'll point out when that might not be the case so let's start with a deeper dive into managing winners so managing winners is one of the most classic tasty strategies when it comes to our approach to the overall markets essentially what we want to do is close our positions when they reach some percentage of Max profit usually around 50 percent of Max profit although this can vary depending on the specific strategy in question remember that when you're selling options your max profit is capped by the credit that you collected so the closer you get to 100 of credit collected the more you're risking to achieve greater percentage returns that just doesn't make sense to us so instead when the market moves in our favor we prefer to take the trade off book that win and move on one of the ways that you can easily implement this strategy is by using GTC orders or good till canceled orders set them at 50 of Max profit or whatever profit level you might be looking at and then when the market gets there you will automatically get out okay so there is a brief look at managing winners which is more of an offensive strategy right this is more of a strategy for the trades that work what do we do for the trades that maybe don't work what do we do for the times when as rare as they might be we happen to have a losing trade on our hands let's take a look so unfortunately losing trades is inevitable it's going to happen nobody Bats 1 000 in the market so when it does happen you need a strategy now what follows is specifically aimed at undefined risk strategies only because Define risk strategies already have a loss mitigation mechanism built in with that long option in the strategy defining your max loss now generally there are two basic strategies to managing losers there's managing at some predetermined multiple of credit received or just holding indefinitely with no predetermined exit Point both of which are pretty simple and pretty straightforward a predetermined exit Point simply means you're going to exit when your credit reaches 2x or 3x of credit received so for example if you sold the string angle for two dollars a 2X loss would be the strangle selling for six dollars you lose four dollars or two x of your original credit received and a three x loss would be the strangle selling for eight dollars you lose six dollars or three x your original credit received pretty simple and pretty straightforward now no predetermined exit point is even easier I mean you have no exit Point planned and you simply monitor the position on a regular basis and you decide when it's time to finally exit based on your perception of the position the portfolio risk metrics or whatever you decide to look at at that point in time so which should you choose well you could really go either route and the tasty research has shown there isn't really a clear Advantage either way but I would say if you're brand new then having a predetermined exit Point makes a lot of sense whether it's 2x or 3x of credit received there are Gamers and gotchas to both I would just choose one stick to it for a while and see how you like it from there you will likely make adjustments to fit your own personal trading style okay so that's managing losers which is more of a defensive tactic let's now turn our attention to the third and final management strategy that we're going to look at here today which is managing early it's a bit of a hybrid between managing winners and managing losers so managing early is a more recent management approach that's come online maybe the last three years or so at Tasty and it involves closing or rolling the position long before expiration day specifically at 21 days to expiration in the cycle the strategy is a hybrid because it actually possesses characteristics that will help boost profitability and characteristics that will help control risk from a profitability standpoint it helps because the research has shown Theta to be more reliable in the first half of the cycle so by managing at 21 days to go so here we're able to tap right into that which ends up improving our p l but it also helps risk too because you remember little old gamma and how a few episodes back I wanted to put it on the Shelf until the right time well that time is right now gamma as you might recall measures how Delta itself moves as the underlying stock moves so it is very much an added layer of directional risk so the more gamma you have on a position the more added directional risk you have on that position because your Deltas are going to change more and more quickly well gamma naturally Rises as you approach expiration a phenomenon often referred to as gamma risk and this is something as premium sellers that we are trying to avoid well by managing at 21 days to go we're able to effectively eliminate gamma risk completely because we never get close enough to expiration for it to really matter which must be valuable because the tasty research has shown that most big losers do tend to occur in the second half of the expiration cycle so managing early is an effective strategy which could be used by both Define risk and undefined risk strategies but it is really more suited for undefined risk strategies because those are the strategies that are exposed to gamma risk alright so there is an overview of how to manage your positions on a day-by-day basis and what you are looking out for and again definitely use the strategy management crash course as a supplemental resource to what we just went over but in addition to that strategy management crash course there's actually another resource that I would also recommend at this point so we just covered three different management techniques managing winners managing losers and managing earlier well there's actually a fourth option that we use on a very very regular basis rolling now as luck would have it we actually have an entire crash course all about rolling that's also on the YouTube channel so I would absolutely check that out and it will serve as a great addition and as a great extension of what we talked about right here and right now all right so I kind of can't believe it but we are really really close to the end the train has almost reached its final destination that is the options crash course 2023 there's just a few more things that I want to drop on your doorstep a little bit more mortar that I want to fill in between the bricks before we wrap it up and call it a day on this crash course and these things are coming in this final section of the course now in this final section my main objective is this I want to try to tie up some of the Loose Ends that still might be flapping in the wind after all the work that we've done up to this point now full disclaimer even after we get done with this section even after we tie up a couple of these loose ends you will still have questions there is almost certainly still some things that are unclear there are still some things that I didn't explain hopefully enough there are still some things that you're slightly confused about all along the way I try to be as complete as I could be about a given concept about a given strategy about a given idea but I almost assuredly fell short in certain spots so what I want to do at the very end of this section is I want to give you some resources I want to point you guys in the direction that's going to help you get some of those questions answered but for right now in this section I want to address four things I want to talk about liquidity I want to talk about implied volatility rank I want to talk about position sizing and then I want to talk about the most important thing that you need to be successful as a trainer we'll do that at the very end to try to build up a little bit of drama here in this final section so liquidity now I mentioned this way back in the beginning in the marketplace functionality section when the crash course had just begun it is critical it is absolutely Paramount that you only trade the most liquid stocks in the world you trade these stocks and these underlyings exclusively you only focus on the most actively traded stocks in the world this is going to do a few things number one it's going to ensure that you're able to transact at fair prices it's going to ensure that you're working with tight bid ask spread differentials and you're buying at a fair price and you're selling at a fair price but also number two it's going to ensure that you can get in when you want to get in and you can get out when you want to get out there is nothing more frustrating than getting a trade right but not being able to get out there is nothing more frustrating than having a trade that you really really like but not being able to get in well focusing on the highest of the liquidity stocks in the world is going to really really minimize the chances that you run into those situations now to do this I mean we could talk about stock volume and option volume and open interest and all these different things and you should Google these different things inside of the tasty website you should look into these things on your own but what I want to do right now let's make this as simple as we can and as efficient as we can and I have a great resource for you right inside of your tasty platform so inside of the tasty platform you already have pre-loaded watch lists where the stocks are screened by various metrics and if you're just starting out I would strongly recommend focusing on two watch lists the tasty default watch list and Tom's watch list these watch lists basically give you all the stocks that we all trade day in and day out and they will be the most liquid most actively traded stocks in the market so effectively anything on these lists is going to be set and ready to go in terms of liquidity all right so that's liquidity let's now turn our attention to implied volatility rank or ivr we've already looked at implied volatility a number of different ways we've looked at implied volatility inside of the option pricing models themselves with a black shelves model we've looked at implied volatility and its relationship to realize volatility and we've you know been introduced to how important that relationship is what I want to do now is offer up a third angle to implied volatility housed within this idea of implied volatility rank or ivr so let's take a look so ivr effectively measures IV relative to itself over the previous 12 months much like a standardized test score it essentially shows you where you stand in the distribution of implied volatilities over the last year so for example if your ivr was 40 that means the current IV is in the 40th percent Gentile of the previous year's distribution of implied volatilities if the ivr was 75 then the implied volatility is in the 75th percentile of the previous year's distribution of implied volatilities and if the ivr was 106 then that means that the current implied volatility is actually six percent higher than the previous range of implied volatilities over the last year so what this effectively shows is where implied volatility sits relative to itself now why is that important well another aspect of IV that has both mathematical and empirical support is that IV is a mean reverting metric when it's on the higher end it's more likely to fall back to its mean and when it's on the lower end it's more likely to rise back to its mean and now that we have implied volatility rank we can take advantage of that we can take advantage of that because when ivr is higher than short premium strategies might have an advantage as following implied volatility would reduce option prices and when ivr is lower the long premium strategies which we didn't cover directly in this course but you can certainly learn about on the tasty site might have an advantage as rising implied volatility would lift option prices now of course as is the case with everything else in the marketplace nothing is certain and there are no guarantees so while volatility mean reversion has been shown to be reliable over time there is no guarantee that it's going to mean revert when you want it to mean revert or needed to mean revert okay so there's a quick overview of implied volatility ranks certainly not everything there is to ivr but hopefully enough to get you up and running and to help you start to make better decisions with trade entry trade exit trade management strategy selection and all these different things but next let's turn our attention to position sizing which is actually critically important when it comes to your success or like thereof as a budding Trader so one of the core tenants of the tasty philosophy is to stay small with your position sizing as we want to give the probabilities a chance to work over time so naturally that begs the question what is small well here it's important to differentiate between Define risk strategies and undefined risk strategies because Define risk strategies will naturally be much smaller than undefined risk strategies just by the very nature of the risk being defined and the max loss being known so with defined risk strategies generally speaking one to five percent of your total account net like per position is pretty small if you have more Capital to work with like 50 000 or 100 000 or more then you can easily hit the lower end of this range if you have less Capital to work with like let's say 10 000 or 7 000 then you'll likely be on the higher end of this range with undefined risk strategies a range of three to ten percent of your total net leg preposition is also pretty small again if you have more Capital you'll be on the lower end of this range if you have less Capital you will be on the higher end of this range certainly not a hard and fast rule that must be obeyed at all times but these ranges will give you a really good starting point for sizing your positions correctly alright so liquidity is in the books in pi volatility rank is in the books position sizing is in the books this brings me to what I believe is the most important thing that will determine your success or lack thereof as a Trader and it's very much in line with what we just talked about with position sizing staying small this alone this One Singular thing alone I believe it is what is needed to unlock whatever you're looking for in the world of options in the world of stock in the world of Futures whatever product you ultimately want to use I believe that staying small on order entry is the most important part of the whole process this is because when you stay small on order entry here is what you're able to do you're able to manage your risk you're able to build your profits you're able to act strategically you're able to analyze objectively all things that can be traced back to having the right position size on at order entry specifically a very very small position size if you don't stay small enough on order entry you're gonna find for yourself it's very hard to control your risk it's very hard to act strategically and it's very very hard to make decisions objectively but all of those things can be avoided as long as you stay small on order entry and I kind of can't believe it but we made it we made it to the very end of the crash course the options crash course 2023 it's over it's done it's in the books and let me just say that I am so thankful for you guys for those of you that went all the way through even if you just bounced around and just grabbed the content that you needed I'm so thankful for you and I'm so grateful that you chose to invest in my content like thank you thank you thank you from the bottom of my heart I'm so humbled that those of you choose to spend your precious time and effort and resources into some content that I've created so thank you guys very very much if you guys are going along and you have questions and you want to reach out to me personally please do so like I am here it is my absolute pleasure but also for some additional resources that might be able to answer some of the questions that you still have you know left unanswered from this crash course I would check out all the other terrific programs that we have on the tasty Network Monday through Friday all kinds of different shows all kinds of different personalities all kinds of different angles where you can find a wealth of information and resources to help you learn more to help you understand new things and to find answers to those questions that you might still have so that is it that is a wrap the options crash course 2023 has come to a close I appreciate you guys I thank you guys and if I can help in any way you guys let me know until then I will see you guys next time

Channel: tastylive

Views: 77,398

Keywords: Tom Sosnoff, Day Trading, Trader, tastytrade, tastyworks, Victor Jones, Dylan Rattigan, Luckbox Magazine, DailyFX, Options Trading, Options Trading Adivce, how to trade stocks, day trading live, day trading for beginners, How to Trade Options for Beginners, Options for Beginners, options trading for beginners, options trading, options robinhood tutorial, options robinhood explained, small account options trading, call options example, call options explained

Id: 89NHBLDTQyk

Length: 116min 34sec (6994 seconds)

Published: Sun May 28 2023