Options Trading 101

In this post, I’ll explain how to trade options based on what I learned beginning in the 1980s while working as a professional trader, and ever since those crazy days of oil tycoons and huge expense accounts.

First, I’ll cover the basics of options trading. Next, I’ll step you through the most basic option trading strategy, covered calls. Then, I’ll give an example of how you can add layers to the simple covered call strategy to reduce risk and increase the probability of a favorable return.

This will leave you with the basics you’ll need for learning how to trade options, plus a more advanced understanding of how to trade options beyond just the simple covered call strategy.

Why Learn How to Trade Options?

At the core of all successful trading and investing, you’ll find risk management and increase the probability of winning trades. Smart traders and investors learn how to trade options to accomplish this with less capital.

Professional money managers do this, and individuals can do this, too, given the correct information and training.

What is a Stock Option?

A stock option is a privilege that gives the buyer the right, but not the obligation, to buy or sell a stock at a specific price within a certain time frame.

Advantages and Disadvantages of Options Trading

The advantages to options trading are many. As we all know, there’s no such thing as a free lunch. Options trading definitely comes with some disadvantages as well. Having experienced most of them since I first learned how to trade options back in the 1980s while trading for a NYSE listed firm, I’ll outline them below.

Advantages of Options Trading

Some advantages of options trading are outlined below.

Leverage

Leverage is one of the biggest advantages of stock options. Think of purchasing a $100,000 piece of real estate with leverage by making a 20% down payment of $20,000.

That down payment allows you to control $100,000 worth of real estate by using only $20,000 of your capital. Similarly, options allow you to control a larger amount of securities with a smaller amount of capital than the full value of the underlying security.

Just like real estate leverage, leverage from options trading can be a dual-edged sword; use very carefully and wisely. This is to most important thing to understand when learning how to trade options.

For this reason, a primary focus of the trading system I developed, the Power Cycle Trading™ model, is risk management. When used incorrectly, leverage can wipe out your wealth, whether that leverage is from real estate or stock options.

Lower Investment Equals Less Risk

As shown above, if you can control a set amount of securities for a fraction of the full value of those securities, you can use less of your capital. For example, you can purchase LEAPS (a type of long-term option) instead of a buying a stock outright.

Let’s say the LEAPS cost $1,000 and the stock costs $5,000. If the company goes broke, you’ve lost $1,000, not $5,000. Your capital at risk was $1,000, not $5,000, in this example. This equates to less money, less risk. Ironically, options – inherently considered riskier than stock ownership.

Option Strategy Alert: It’s important to note here that the value of the LEAP contract deteriorates slowly over time. This can actually be used beneficially, however, by the educated option trader, as I teach at Power Cycle Trading™.

It’s also important to note that just like the stock, however, the LEAP value can go up or down. In other words, both stocks and LEAPS have risks and opportunities.

How to Trade Options to Protect Investments

A common and simple example of using options to protect your traditional buy and hold stock portfolio is used with puts. Let’s say you’re long on the stock market. Maybe you have a retirement portfolio that has grown over the years to become a comfortable nest egg.

Let’s assume the stock market has been in an extended bull market for a while. You don’t want to sell your stock holdings, triggering taxes and the possibility of missing the rest of the bull move up. Yet, you’re so worried that a bear market will devastate your nest egg.

This is when buying puts can act as an insurance protecting the value of your stocks. Just like insurance, however, there is a cost, but that cost can more than offset the protection you get when selling puts correctly. Plus, you can sleep better at night. What’s that worth?

How to Trade Options as Income Generators

Some options trading strategies can be used to generate monthly/quarterly income. More and more retirees are learning how to trade options for monthly income given the paltry interest rates being received from bonds.

One of the most common examples of an option strategy that generates monthly income is Covered calls. (Risk Alert: Covered calls are a bull market strategy unless a ‘collar’ added to protect your position, as shown in my Free Options Trading Made Simple eBook Here)

Another common income strategy is credit spreads. This strategy is a Power Cycle Trading™ favorite, since it is appropriate for both bull and bear markets. I covered this more below.

Options Trading Can Work in Both Bull and Bear Markets

Do you hate waiting out bear markets to make money, especially while watching your net worth decline? Then there’s the issue of getting into riskier, overvalued bull markets near the end of the cycle. Option strategies give traders and investors the opportunity to make money no matter which direction the overall market is moving. In trader lingo, this is called Non-directional.

Inside Edge

Let’s face it; options trading is complex. In fact, complexity is one of the disadvantages listed below. The flip side to this complexity is that fewer people are willing to learn how to trade options. This is true of financial professionals as well as individual investors.

While many financial advisors would like to add covered calls to their services to provide income for their clients, few do so because it is a lot of work to sell covered calls for hundreds of clients.

Not only this, but volume can be too limited to financial pros. It’s easy, however, to sell covered calls as a nimble individual investor or trader, providing a little known and rare advantage for the individual investor over Wall Street.

Other options trading strategies are definitely more complex than covered calls. Credit spreads and the option butterfly are among the more complex options trading strategies taught at Power Cycle Trading™. This is because they add a built-in layer of protection in the event that the security moves in a way you had not expected.

Because of all of this, those willing to learn how to trade options are at a huge advantage.

How to Trade Options for Tax-Free Income

Covered calls can be used inside of an IRA account. This allows an investor to defer or avoid tax on the income gained from selling the option. Since taxes can eat into an investor’s profits, this can be a huge advantage.

Note that it cannot use more complex options trading strategies inside IRAs as of this writing.

Disadvantages of Options Trading

Some of the disadvantages of options trading are outlined below.

Higher Margin

Brokers can require a higher margin for some option strategies. This can vary among brokers. Be sure to check and make sure you have found an option friendly broker.

Stock Options Time Decay

Owning options can be like holding a ticking time bomb. This is because the value of the option decreases the closer you get to the time the option expires. For this reason, when I teach others how to trade options I tend to focus on trading strategies that buy options instead of selling them. This allows an options trader to start with a huge advantage right out of the gate.

You can watch my video about time decay here:

The Complexity of Options Trading

As you read above, there’s no doubt that learning how to trade options is more complex than simple stock investing. Like most things which seem complicated at first, they become simple with learning and practice. Few opportunities are easy for any length of time, or everyone would be doing them, eliminating the opportunity factor.

Limited Use of Options Trading in IRA’s

As mentioned above, only the simplest of options trading strategies are allowed in IRA’s. Interestingly, big companies inside your IRA issue options and many use options to hedge for commodities and currency. (I used to help companies do this for a living!)

Not only this, but many, if not most, funds use option strategies for protection, income and leveraged returns. Yet individuals are not allowed to do options trading inside their tax-sheltered accounts. (Big brother knows better, right?)

The Basics of How to Trade Options

Shares Vs Options

One options contract represents one hundred shares of stock. A simple example can be used with covered calls. An investor buys one share of stock and then sells 1 call option “against” the one hundred shares of stock.

They often refer the stock shares to as “underlying”.

Options Expiration

The expiration date is the third Friday of the month for monthly options. For this reason, options trading volume tends to surge near this time.

Now, weekly options trading is also very popular. This options strategy trades options that expire every Friday.

When first learning how to trade options, “Weeklies” offer a faster learning curve. I recommend, however, that everyone begins with “paper trading” when first learning how to trade options.

Strike price

The strike price is the price at which the security will be bought or sold if the option contract is exercised. Strike prices are often in $1 to $5 increments, depending on the price and volume of the related, or “underlying” security.

Option Premium

This is the sales price of the option. When you sell an option, the premium gets deposited right into your brokerage account. This is why covered calls are so popular.

Risk Alert: And the reason they are also unpopular at times is that most covered call gurus don’t warn clients about this. When instructing students how to trade options at the beginner level they often fail to mention that simple covered calls alone are best for bull markets.

Covered calls work best in bull markets because the value of the underlying stocks drops with the market, as explained in more detail here.

How to Trade Options in Your Brokerage Account

Options trading is done in the same way that you buy and sell stocks in your brokerage account.

You must apply to get options trading approval first. There are three levels of options trading for which you can apply. The easiest level is for covered call writing. Before you even begin learning how to trade options, go ahead and ask your broker for an application or download the form from your broker so the approval process can begin.

Types of Options by Time Frame

Monthly options expire every month, although they can be exercised before expiration. More recent weekly options, also called “Weeklies”, expire every 8 days. LEAPS are longer-term options lasting 9 to 30 months. LEAPS always expire in January.

Note that options trading can be applied to day trade, swing trade over a few days or weeks, or even invest for years.

Put Options and Call Options

A put option gives the owner the right to sell a security at a certain price on a certain (expiration) date.

A call option gives the owner the right to buy a security at a set price on a certain (expiration) date

It’s important to remember that stock options give the right to buy or sell a security (underlying) OR they have the potential obligation to buy or sell the underlying security. It depends on whether you’re the buyer or seller.

How to Trade Options for Buyers Vs Sellers

For the Buyer:

A Call gives the right to buy the underlying stock

A Put gives the right to sell the underlying stock

For the Seller:

A Call gives the potential obligation to sell the underlying stock

A Put gives the potential obligation to buy the underlying stock

The seller is only obligated if the buyer exercises the option. What you are about to read next is very important: The overwhelming majority of options expire unexercised.

This is the beauty and HUGE advantage of being an option seller over being an option buyer. This means that the option seller can sell an option, collect the option premium in her brokerage account, and nothing else happens other than the seller keeps the option income.

When learning how to trade options, this is the most important concept to understand.

How to Trade the Covered Call Option Strategy

Now that you may be wondering why you ever decided to google how to trade options, let me give you a real example that will clarify things. We’ll start with a simple options trading strategy, the “Covered Call”. This will step you into learning how to trade options without overwhelm since this is the most basic options trading strategy.

The Covered Call is a longer-term strategy used mostly by longer-term investors (and a few institutions for their clients). It is the simplest options trading strategy and demonstrates both the buyer and the seller of call options easily.

This strategy is really a hybrid between long-term investing and options trading as you’ll see below.

Joe owns 500 shares of Income Inc stock that he bought for $40 each.

He is tired of earning the tiny 2% annual dividend on this stock while tying up a lot of his capital.

He heard that you can earn income from your stocks if you sell call options “against” your stocks. After learning how to trade options using the covered call strategy, here is what he does:

On September 6, he sells 5 October call options on Income Inc. with a $42.50 strike for $1.00 each. He gets $500 income deposited into his brokerage account for selling those call options, which is a pretty nice 2.5% return in 6 weeks.

He notes that this is a LOT better than the 2% he earns annually in dividends! Not only this but if the option isn’t exercised, he’ll still own the stock. He’ll earn the dividends, too.

Here is what this means: Joe has given the right to the buyer of the call options to buy the stock from him on the third Friday of the month (or before) at $42.50.

Fast forward to option expiration

Here’s what happened on expiration Friday. The stock went to $42. The option expired without being exercised since the value of Income Inc is less than the strike price of $42.50.

Joe got to keep the stock, and he made $500 from selling the call options. He decides to sell call options again for the next month out.

If the Stock Went Up More

But what if the stock had gone to$ 43? Joe could have:

Bought the call options back. On the day of expiration, the price of the option would have been around .50 in this example. (Remember, the price of the option declines the closer the option gets to expiration, all other things staying the same.)

If he bought the call option back for .50, he would make .50 on the option:

$1.00 Price he sold the option for – .50 price he paid for the option = .50

This would have been a 1.25% return in 6 weeks, or 10.8% annualized. This sure beats the dividend rate of 2% a year, plus it’s in addition to the dividend.

(Note that Joe would have made money on the Time Decay, a very important options trading concept.)

As long as Joe owns the shares, he can then sell options for the next month. It would be smart if he first checks to see where the stock is in its shorter-term cycle on a stock chart before selling that option since it can increase his opportunity to make more income from the stock.

In other words, stocks tend to move in mini-cycles within larger cycles. By selling the call option near the top of the mini cycle, Joe can make more money because the price of the call option moves in relation to the underlying stock. Cycles are best seen on stock charts.

If the Stock Goes Even Higher

But what if the shares went to $44 on or before option the expiration date?

That would be a bit of a bummer since he is obligated to sell them at $42.50. But how bad is it? We view charts as a very valuable free tool at Power Cycle Trading™.

Joe could review a short-term chart to help him make the best decision, and he could…

♦ Sell the stock at the strike price of $42.50 to the option buyer. Remember, he was obligated to sell the stock at the strike price if the buyer chooses to exercise her option, which she would do if the stock price is over the strike.

In this case, Joe still made $2.50 a share on the stock, plus $500 ($1 per option contract) from selling the option. (This guaranteed $500 option premium was the trade-off for missing part of the upside of the stock.) $2.50 per share plus $1 per contract = $3.50 profit

$3.50/$40= 8.75% return…not too shabby

OR…

♦ Joe could buy back the option and keep the stock. He would have a loss in the option, probably of about 50 cents per option contract.

Note that he could probably sell another call option further out in the future to cover this small loss completely, if not turn it into a gain.

$1.00 (Joe’s original sale price) – $1.50 (the estimated price of the option on the expiration Friday, which is calculated as $44-$42.50)

But wait! Joe would lose 50 cents on the option contract (before commissions!) but he made $4 a share on the stock if he sells it, or he has an unrealized capital gain on the stock if he keeps the stock instead of selling it.

Then he can sell another option with a higher $45 strike for the next month or 2, and indefinitely, raising the strike price each time if the stock keeps rising!

Joe can also benefit from using some very simple technical analysis to help him maximize his returns on his investments and covered call income.

This simple covered call strategy was used to give you perspective on how call options work for both the seller of options and the buyer of the options.

As mentioned, covered calls are a bull market strategy. This means covered calls are best for rising markets.

This is because you must use a lot of capital to buy the underlying security, the stocks, against which you sell the call options.

Risk Alert: If the market enters a bear cycle while owning these stocks, the value of the stocks will drop along with the rest of the market. Once this happens, it becomes almost impossible to sell call options with a strike near your cost since the market has dropped.

In this case, the covered call writer has incurred a drop in the value of her net worth, along with losing the ability to generate covered call income from the stocks she already owned. This is a double pain.

How to Trade Options to Lower Risk

At Power Cycle Trading™, I teach options trading strategies that add a layer or two of protection to simple strategies like covered calls for when the inevitable drop does happen, or you’re just plain wrong in predicting the direction of a stock.

While the Power Cycle Trading™ model pulls in technical indicators that help decrease the probability of being wrong, there is no holy grail. We’re all human and make mistakes when investing.

Why not create a little hedge for those occasions of being wrong, just like the big companies do? If you think about it, it’s pretty amazing that individuals can even do this.

An Example of Using an Option for Lowering Risk

A simple example of protecting the covered call position, or hedging, would be to buy a put option at the time the stock is purchased, and when the covered call is sold. Here is why: the value of the put will go UP if and when the value of the stock goes DOWN.

At its’ most basic form, this option strategy is a type of insurance. Just like your auto liability cost you, it’s worth the premium you pay for it when the inevitable unexpected happens.

In the same way, the put option will cost you since you must buy the put, but the protection is often worth it. This is especially true toward the end of strong bull markets.

In this example, remember, the value of the call option would go DOWN, allowing you to buy it back cheaper, giving you a profit on the call options.

In essence, you get to be right, even when you’re wrong! That is the beauty of option trading strategies.

Adding another leg or two to your investing and trading strategies for an added layer of protection is wise. What you don’t lose is as important as what you make.

More and more traditional, long-term investors are learning how to trade options so they can use puts to protect their stock portfolios.

For this reason, two popular methods I teach are Credit Spreads and Butterfly Options trading strategies. In my virtual trading room, we also enhance the entire options trading process with the Power Cycle Trading™ model to get a better idea of whether the underlying security is more likely to move up or down while holding the security. Marrying these powerful tools increases the probability of a more favorable outcome from any investment or trade.

If you’d like to see all of the most popular options trading strategies, such as the Butterfly Option strategy or Credit Spreads, along with detailed diagrams and explanations of when they work best, then be sure to grab a copy of my free option trading eBook below.

About Me: Options trading is at the core of the company I founded, Power Cycle Trading™ and here’s why. I first began options trading in the mid-1980’s while trading crude oil for a NYSE listed firm. I continued to trade billions of dollars’ worth of securities internationally and professionally for the next three decades using both options and futures. Incorporating what I learned as a professional trader, with being an individual investor and teacher of options trading now, options continue to fascinate me due to their many unique advantages to lower risk and increase winning probabilities in ever-changing market environments.

Disclaimer

The following is purely for educational purposes. Any stocks mentioned DO NOT constitute advice and should NOT be construed as recommendations.

U.S. Government Required Disclaimer – Commodity Futures Trading Commission. Futures and options trading has large potential rewards but also has a large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the futures and options markets. Don’t trade with money you can’t afford to lose. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed on this website. The past performance of any trading system or methodology is not necessarily indicative of future results.

CFTC RULE 4.41 – HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN.

There is a very high degree of risk involved in trading. Past results are not indicative of future returns. Powercycletrading.com and all individuals affiliated with this site assume no responsibilities for your trading and investment results. The indicators, strategies, columns, articles and all other features are for educational purposes only and should not be construed as investment advice. Information for any trading observations are obtained from sources believed to be reliable, but we do not warrant its completeness or accuracy, or warrant any results from the use of the information. Your use of the trading observations is entirely at your own risk and it is your sole responsibility to evaluate the accuracy, completeness and usefulness of the information. By downloading this book or any information from Powercycletrading.com your information may be shared with our educational partners. You must assess the risk of any trade with your broker and make your own independent decisions regarding any securities mentioned herein. Affiliates of Powercycletrading.com may have a position or effect transactions in the securities described herein (or options thereon) and/or otherwise employ trading strategies that may be consistent or inconsistent with the provided strategies.

OPTION BUTTERFLY TUTORIAL

The Option Butterfly Spread is one of the best, if not the very best, option trading strategies. Yet this dynamic trading structure is little used by option traders. Here’s why: it seems complicated to most people. Therein lies a golden opportunity for those few individuals willing to spend a little time understanding how to trade the option butterfly spread.

In this article, I’m going to simplify the Options Butterfly Spread for you. It’s true that the setup can seem overly complicated initially. This is because most traders try to master the Butterfly without truly understanding a few basic option trading principles first, all of which you’ll find covered below.

The reality is that once you grasp these basic concepts, you’ll see that the Butterfly is just marrying a couple of simple setups that you probably already know. Serious traders take the time to master the skills to increase their returns while lowering their risk, and the Butterfly is one powerful way to accomplish this. By taking time to master the Butterfly Option Spread, you’ll gain a powerful edge over others who continue to avoid it.

Why The Option Butterfly Spread Is So Powerful

As all traders and investors know, market direction can go through months and even years of higher than usual uncertainty. At times, technical analysis may be painting one picture, while the economic or political environment is painting another. This can be both stressful and costly. Yet, waiting on the sidelines has opportunity costs. Not only this but for many traders who have come to rely on regular income from trading, loss of that income can cause serious lifestyle problems.

Then there’s the random earnings news, political winds, or slightly negative economic factor that can wreak complete havoc on an otherwise perfectly excellent option trade setup. These are all factors way beyond our control that we never even considered when structuring a trade setup that has worked many times before. We’ve all experienced this!

All of these situations call for a strategy that will work no matter which direction the market or any specific stock heads. This is exactly what the highly versatile Butterfly strategy does. It gives you a trading advantage in any type of market environment. This makes it a powerful strategy that every serious trader will want to add to their arsenal of skills.

Now there’s no such thing as a free lunch: Butterfly spreads cannot offer unlimited profit potential since their built-in risk management structure eats into returns. But they usually cost less than buying options outright for protection while providing a powerful positive risk-reward trade setup that simply cannot be found with other trading strategies.

Now that you know why you want to know how to trade Butterflies, here are the basics that you’ll get in this article.

Best Market Conditions for Butterflies
Benefits of Butterflies
The Option Basics You Need to Know First
The Most Important Option Factor
Types of Butterfly Spreads
My Favorite Butterfly Trade Setup

The Best Market Conditions for the Option Butterfly Spread

Unlike other option strategies such as iron condors, credit spreads, or debit spreads that only work with an identified objective based on probable market direction, as noted earlier The option butterfly spread can be set up and traded for a variety of objectives based on where a trader thinks the security or market is headed.

Non-Directional – You Have No Idea Where the Market is Headed

In their simplest form, butterflies can be delta neutral or non-directional trades. This means they can be used successfully when you simply DO NOT KNOW the market direction. Trying to pick the direction of stocks or the overall market can be stressful and expensive. Delta neutral butterflies can be set up to take the guesswork out of trading. This is particularly advantageous because it can allow you to trade successfully when you would otherwise need to wait for clear market direction.

Directional – You Feel Pretty Sure the Market Is Headed Up or Down

The Directional Butterfly Spread can also be used for bullish or bearish exposure to the market while also managing risk and retaining large potential returns. This directional structure is used when you see a high probability of market direction based on technical analysis or other tools.

Hedging – You Don’t Want to Lose Your Shirt!

The Directional Butterfly can also be used as a fast way to hedge on positions that are moving against you. This is exactly what the most sophisticated companies do. They hedge, and now so can individual traders! Hedging lowers trading stress, and who doesn’t want that?

The Benefits of the Option Butterfly Spread

Flexibility

The option butterfly spread provides flexibility with the ability to alter a previous trade. For example, you can construct an option butterfly around a strike that is under pressure from another core trade, such as a credit spread or debit spread.

Time Buying

We’ve all been in situations where we just need a little more time for a trade to work out perfectly. Adding a Butterfly leg to an existing trade allows you to keep the original position open while buying more time. Often, additional time is all that’s needed for a trade to move back to profit territory. At that point, you can then remove the butterfly hedge and stick with your original trade.

Cheap Risk Management

Butterflies provide cheap protection! For example, many longer-term investors and swing traders buy puts for portfolio insurance. Long-term out-of-the-money put butterflies, however, can be a much cheaper method of portfolio protection than pure long puts. While no insurance is free, this trade setup is among the cheapest ways to protect your precious capital.

Income

Butterflies can be used to generate income from stocks that appear to be going nowhere in the short term but are tying up precious time, capital and energy. This can provide more steady income for retirees. Not only this, but income also enhances overall portfolio returns in flat markets.

Risk Reward

A 10-to-1 or higher Reward-to-Risk is common with the Option Butterfly Spread. Where else can this high potential ROI be found? This unusually high-risk-reward ratio makes them well worth the effort to learn the structure.

Low Maintenance

Butterflies are sometimes called “vacation trades”. You know how you can have a trade open before your vacation that you thought you would be out of before your vacation arrived? Then your vacation time arrives, and you know you should close out the trade because you don’t know if you’ll have the time, or even the WIFI to monitor the trade effectively. But you really, really don’t want to close out the trade. Butterfly option setups allow you to go on vacation with the trade open and here’s why: their low-risk profile and need for only very infrequent monitoring. Just make sure the expiration date is not near or during your vacation as shown in the diagram below.

Butterfly trades are generally very slow moving early on in the trade.
But get more exciting and volatile as they approach expiration and are within the profit tent (Zone).

A Few Option Basics You Need to Know First

Now that you’ve seen all the reasons that the option butterfly spread technique has a very devoted but small following, let me explain the few important basics that you’ll want to fully understand before trading Butterflies. Option measurements use of Greek terms. (Go figure!)

The “Greeks” provide a way to measure the sensitivity of an option’s price to quantifiable factors. The Greeks are strictly theoretical. That means the values are projected based on mathematical models. Why do you want to know this? Because all of the best commercial options analysis packages will provide these excellent option analysis tools for you. On some of the better brokerage sites, they are absolutely free. So, regardless of whether or not you ever trade Butterflies, you’ll want to fully master these concepts if you haven’t already if you trade options at all.

3 Important Greek Tools

You’ll want to be familiar with these Greek terms because they are the terms you’ll see on your brokerage platform when you trade options. I’ll explain each of them in everyday terms and in the paragraphs ahead.

Theta measures the time decay of an option contract. Time decay happens per day. The rate of Theta, or time decay, increases each day as the option contract approaches the expiration date. Theta is zero at option expiration. The smart option trader uses Theta to his advantage, as you’ll see below.

Implied Volatility is the price movement of an option. The marketplace “implies” what the volatility of a stock will be in the future, and what its effect on the price will be.

Delta measures the price movement of the option contract in relation to a $1 change in the underlying security. An option contract doesn’t move dollar for dollar with the underlying security. By using the Delta, you can see the price movement relationship between the option and the security.

The Most Important Option Factor

The most important factor for successfully trading the option butterfly spread is the simple concept of TIME and its dynamic effect on the price of an option. Once you fully understand this, you have a huge advantage for successful option trading. Here is why: You can capitalize on the accelerated time decay of an option contract as its expiration date gets closer. This concept is pure gold!

This decrease in option value toward option expiration is called Time Decay. Option Butterfly Strategies heavily take advantage of Time Value, and the impact it has on the price of an option. Remember, you’ll see the term Theta to represent this Time Decay in your brokerage account.

The Value of an Option

To expand on this important concept further, the Time value (also called extrinsic value) of an option is the premium a rational investor would pay over its current exercise value (also called intrinsic value), based on its potential to increase in value before expiring. Note that this probability is always greater than zero, thus an option is always worth more than its current exercise value.

Option Theta Summary

In summary, Theta tells you how much an option’s price will diminish over time, which is the rate of time decay of a stock’s option. This time decay occurs because the extrinsic value, or the Time Value, of options diminishes as expiration draws nearer. By the option expiration date, options have no extrinsic value and all Out of the Money (OTM) Option expires worthlessly. The rate of this daily decay all the way up to its expiration is estimated by the Options Theta Value.

As you can see, understanding Theta is extremely important for the application of option strategies that seek to profit from time decay. You can think of Theta as a measurement toward winning trades.

Options Theta Characteristics

Let’s expand your knowledge of this important concept further. Option Theta values are either positive or negative.

All long stock option positions have negative Theta values, which indicates that they lose value as expiration draws nearer.

All short stock option positions have positive Theta values, which indicates that the position is gaining value as expiration draws nearer.

Theta value is highest for At-the-Money (ATM) Options, and progressively lower for In-The-Money (ITM) and Out-of-The-Money (OTM) options.

ITM and OTM options have much lower extrinsic values, giving little left to the decay.

An Example of Theta

An option contract with Option Theta of -0.10 will lose $10 per contract every day even on weekends and market holidays.

This means that the buyer/holder of an option contract over a 3-day long weekend with a price of $1.40 or $140 per option contract and an option theta of -.10 will find the price of that option at $110 instead of $140 after the 3-day weekend! Ouch!

Theta Decay Strikes!

Option Theta does not remain stagnant. It increases as expiration draws nearer and decreases as the options go more and more In-The-Money or Out-of-The Money. In fact, the effects of Option Theta decay is most pronounced during the final 30 days to expiration where Theta soars.

Take a look at the following chart to see just how predictable and powerful this option paradigm is!

How Option Pricing Works

The formula to value an option is below. As you can see, this formula pulls together all of the elements you’ve read about in this article. Once you know these variables then you are ready to price an option and know what its option premium should be. You can imagine how valuable this knowledge is.

Time Value (x) Implied Volatility (x) Intrinsic/Extrinsic Value

The Butterfly Foundation – Vertical Spreads

Now that you have completely grasped the important concept of Time Decay, let’s move to the structure of an Option Butterfly Spread. This is outlined below.

The foundation for a Butterfly Spread consists of two parts, a Vertical Debit & Vertical Credit Spread

A Vertical Debit Spread is done for a debit in your account. It is structured as follows:

A “bull call” spread entails buying one call and selling a higher-strike call that will be lower in price to offset some of the premium cost and theta decay

A “bear put” spread entails buying one put and selling a lower strike put, that will be lower in price to offset some of the premium cost and theta decay.

A Vertical Credit Spread is done for a credit in your brokerage account. It is structured as follows:

A “bear call” spread entails selling one call and buying a higher-strike call that will be higher in price to hedge the short call.

A “bull put” spread entails selling one put and buying a lower strike put that will be lower in price to hedge the short put. You’ll collect an option premium in your account.

Below is a diagram of a Vertical Bear Call Credit Spread.

Types of Option Butterfly Trades

One major goal of every trader should be to select trades based on what provides the most consistent positive return with low, defined risk. This is not always the trade with the greatest return. Traders must learn to avoid the temptation of the pie in the sky trade, so they can learn to love more consistent, lower risk trades.

And one of the best ways to achieve this is by knowing the Option Butterfly Strategies that are available, how they work, and then selecting the one that is best suited for the market environment you are trading.

Below are the variations of Option Butterfly Strategies. There is a strategy for every trading environment and situation.

Long Call or Put Butterfly
Short Call or Put Butterfly
Broken Wing Call or Put Butterfly
Unbalanced-Ratio Butterfly
Broken Wing Unbalanced-Ratio Butterfly
Directional Butterfly
Iron Butterfly
Hedging – Defenses Using Butterflies

Favorite Butterfly Trades & Hedging

As you can see from the many variations of Butterfly Option Strategies, it would be difficult to cover all of these strategies here. What I’ll do instead is provide the exact outline of my favorite Butterfly Option Strategy below.

Long Call or Put Butterfly Spread

This strategy is a combination of a bull call debit spread and a bear call credit spread. Note that it is a limited profit, and limited risk options strategy, as all Butterfly trades are. This is because they contain an income element and a risk management element.

There are 3 striking prices involved in a butterfly spread and it can be constructed using calls or puts. As with all Butterfly trades, this trade is called a butterfly spread because you are short the body and long the wings. This particular strategy can be used as a neutral or directional options trading strategy.

This trade results in a small net debit to your account. The maximum risk is the debit paid to construct the trade. Due to small net debit, this strategy offers an exceptional risk-to-reward ratio.

This strategy capitalizes on being short volatility, and time decay. A target price pinning strategy is also utilized here, as is common with Power Cycle Trading™ methods.

Maximum Profit Potential

The maximum profit occurs if the underlying security is at the middle short strike or body at the option expiration. In this case, the long call with the lower strike would be in-the-money, and all the other options would expire worthless. The profit would be the difference between the lower and middle strike (the wing and the body) less the premium paid for initiating the position if any.

Maximum Loss Potential

The Maximum loss would occur if the underlying security is outside the wings at expiration. The premium paid to initiate the position would be lost.

In summary, Option Butterfly Strategies offer many benefits over other option trading structures. Once you understand the important concept of Time Value, you’ve got the most important element of options trading. There is one foundation set up for Option Butterfly Strategies which has many variations that can be applied to different market environments and goals. If you want to learn more about butterfly trading, be sure to get my eBook here with the information above and much more.

Larry Gaines has become one of the leading coaches for successful traders and investors. He continues to develop and host, every month, new trading educational programs to help traders and investors generate greater income from their investment capital with less risk exposure.

He founded PowerCycleTrading.com and the Power Cycle Virtual Trading Room following over 30 years of professional trading experience in the commodity and equity markets.

During his tenure as head of an international trading company that often traded a billion dollars’ worth of commodities in a single day, he learned first-hand the necessary elements of a successful trading system and the use of options.

Using this in-depth knowledge and experience, Larry developed the Power Cycle Trading™ Model to allow for greater profits with a more disciplined, systematic degree of trading success.

Disclaimer

The following is purely for educational purposes. Any stocks mentioned DO NOT constitute advice and should NOT be construed as recommendations.

CFTC RULE 4.41 – HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS, IN GENERAL, ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN.