Understanding Options Contracts

How To Choose An Options Contract (YouTube link)

The above video offers a basic overview of options trading, focusing on key factors when choosing an options contract. Consider the various expiration dates available. The choice depends on your trading strategy. For weekly trades, focus on the nearest expiration. For swing trades, opt for a later expiration date based on your expectations.

Key Points:

• Platform: The speaker recommends Interactive Brokers Pro (IBKR Pro) for its fast execution speeds.
• Options Chain: This is the interface where you view available options contracts.
• Key Metrics: The most essential metrics include last price, net change, delta, open interest, volume, theta, bid, and ask.
• Delta: Measures the sensitivity of an option's price to changes in the underlying asset's price.  In other words, delta shows how much an option's price changes for each $1 move in the underlying stock. 
• Relationship between option price sensitivity (delta) and premium: Note that options with higher deltas, indicating greater price sensitivity, generally have higher premiums. Conversely, options with lower deltas, indicating less price sensitivity, typically have lower premiums. This is because options with higher deltas are more likely to be profitable if the underlying asset's price moves in the desired direction.
• Open Interest and Volume: High open interest and volume indicate liquidity, making it easier to buy or sell contracts.
• High open interest indicates that many contracts are available, while sufficient volume ensures there are buyers and sellers to facilitate trades. Without enough volume, even a profitable option may be difficult to sell. This is because options are traded in an open market, and finding buyers or sellers is crucial for successful trading.
• Theta: Theta represents the time decay of an options contract, meaning its value decreases over time. Theta decay gives traders an idea of how much the value will drop overnight or in a single day.
• Spread: The difference between the bid and ask price.  Aim for options with narrower spreads to minimize transaction costs and improve profitability.
• Wide spreads can significantly impact profitability, as the difference between the bid and ask price can result in immediate losses. This can be particularly problematic when using stop-loss orders, as the wide spread can trigger the stop-loss before the desired price movement occurs.

Choosing Contracts Based on Theta:

1. Trading Horizon: If you're a short-term trader, focus on options with lower theta values to minimize the impact of time decay. Conversely, if you're a long-term trader, you may be less concerned about theta.
2. Underlying Asset Volatility: High volatility can offset the effects of theta decay. If you expect the underlying asset to be highly volatile, you may be able to tolerate a higher theta.
3. Risk Tolerance: Consider your risk tolerance. Options with higher theta values tend to have lower premiums, but they also decay faster. If you're risk-averse, you may prefer options with lower theta values.

Example:

• Short-Term Trader: If you're trading weekly options, you'll want to choose contracts with lower theta values to minimize the impact of time decay.
• Long-Term Trader: If you're holding options for several months, you may be able to tolerate higher theta values, as you have more time for the underlying asset's price to move in your favor.

Remember: Theta is just one factor to consider when choosing options contracts. Other factors, such as delta, implied volatility, and strike price, should also be taken into account.

Additional Tips:

• Focus on essentials: Start with the most important metrics and gradually add more complexity as you gain experience.
• Avoid noise: Avoid overwhelming yourself with too much information. Focus on what's relevant to your trading strategy.
• Consider liquidity: Ensure there's sufficient open interest and volume to avoid difficulty in buying or selling contracts.
• Be mindful of spreads: Wide spreads can impact your profitability.

By understanding these key concepts, you can make more informed decisions when trading options.

Using Open Interest to Identify Support and Resistance

Option trading basics: How to analyze Open interest (YouTube link)

Summary of Open Interest

Open interest is the total number of outstanding contracts for a specific strike price on an options contract. It represents the number of buyers and sellers who have not yet closed their positions.

How Open Interest is Used:

• Determining Support and Resistance: The strike price with the highest open interest on the put side is generally considered a support level, while the strike price with the highest open interest on the call side is considered a resistance level.

• Reasoning Behind Support and Resistance:

  When a strike price has a high open interest, it signifies a significant number of both buyers and sellers are actively trading at that level. This concentration of interest can create a strong support or resistance level.

  • Support: If the underlying asset's price drops below a put strike price with high open interest, option sellers may face potential losses. To avoid these losses, they might buy more of the underlying asset to hedge their positions. This buying pressure can help support the price and prevent it from falling further.
  • Resistance: Conversely, if the underlying asset's price rises above a call strike price with high open interest, option sellers may be incentivized to sell their positions to avoid potential losses. This selling pressure can act as a resistance, limiting further price increases.

Key Points:

• Open interest is a useful tool for analyzing options markets.
• It helps identify potential support and resistance levels.
• The concept of open interest is based on the assumption that option sellers have more financial power (see Option Seller Margin Requirements below) and are more likely to defend their positions.

Note: Although open interest can be a valuable tool, it's essential to consider it in conjunction with other technical and fundamental analysis methods for a comprehensive understanding of the market.

Additionally, please refer to the final section of the article, 'The Decline of Open Interest as a Trading Tool,' to gain insights into the limitations of using open interest as a sole trading strategy

Option Contract Matrix

Option Premium Matrix

Call Option Margin: Buyer vs. Seller

When buying a call option, there is typically no margin requirement, meaning you only need to pay the premium to enter the position; however, when selling a call option (being the "call option seller"), a margin deposit is required to cover potential losses if the underlying stock price rises significantly. 

Key points: 

• Call option buyer: Only needs to pay the premium for the option, no additional margin needed. 
• Call option seller: Requires a margin deposit to cover potential losses as they are obligated to sell the underlying stock if the option is exercised. 

Reasoning: 

• Limited risk for buyers: When buying a call option, your maximum loss is limited to the premium you paid.
• Unlimited risk for sellers: When selling a call option, your potential losses are unlimited if the underlying stock price rises significantly.

Option margins are complex: They vary based on option type (call/put), position (in/out-of-money), and whether they're naked or covered. For example, naked calls require 100% of proceeds + 20% of underlying value. Read [1] for more details.

Put Option Margin: Buyer vs. Seller

When buying a put option, there is typically no margin requirement, meaning you only need to pay the premium to enter the position; however, when selling (writing) a put option, a margin requirement is usually necessary, as you could be obligated to buy the underlying security at the strike price if the option is exercised, requiring sufficient funds in your account to cover that potential purchase. 

Key points: 

• Put option buyer: Only needs to pay the premium for the option, no additional margin required. 
• Put option seller: Needs to meet a margin requirement based on the underlying security's price to cover potential assignment if the option is exercised.

Reasoning

• Limited risk for buyers: When buying a put option, your maximum loss is limited to the premium you paid, so no extra margin is needed. 
• Unlimited risk for sellers: When selling a put option, you could be obligated to buy the underlying security at the strike price if the option is exercised, potentially leading to significant losses if the stock price drops significantly

The Decline of Open Interest as a Trading Tool

Aditya Trivedi in the above video argues that open interest is no longer a reliable indicator for determining support and resistance levels in the latest options market.

Key Points:

• Historical Effectiveness: Open interest was once a useful tool for identifying support and resistance. However, its effectiveness has diminished in recent years.
• Shift in Focus: Traders have shifted their focus from total open interest to changes in open interest, which has also become less reliable.
• Market Manipulation: Market participants may manipulate open interest data, making it less trustworthy.
• Rapid Changes: Open interest can change rapidly, making it difficult to use as a reliable indicator.
• Alternative Indicators: The author suggests focusing on price action and other technical indicators rather than relying solely on open interest.

Overall, Aditya believes that open interest has become outdated and unreliable as a trading tool.

References

1. Options margin requirements