Options Trading Education Center

1. Position Sizing

Never risk more than 1-2% of your total capital on any single trade.

2. Stop Losses

Always have a predetermined exit point to limit potential losses.

3. Diversification

Spread your risk across different strategies and underlying assets.

4. Time Decay Awareness

Understand that options lose value over time, especially as expiration approaches.

• Over-leveraging: Using too much margin or buying too many contracts
• Ignoring volatility: Not considering implied volatility in pricing
• Holding to expiration: Not managing positions before expiration
• Emotional trading: Making decisions based on fear or greed
• Lack of plan: Not having a clear entry and exit strategy

Implied Volatility (IV)

Implied Volatility is the market's expectation of future price volatility, derived from current option prices. Unlike historical volatility which looks backward, IV represents the market's forward-looking estimate of how much the underlying asset will move.

IV is calculated by working backwards from the Black-Scholes option pricing model. When you input the current option price, strike price, time to expiration, risk-free rate, and underlying price, the implied volatility is the volatility parameter that makes the model's theoretical price match the actual market price.

Practical Applications: IV rank and percentile help traders understand whether current volatility is high or low relative to historical levels. During earnings announcements, IV typically increases dramatically (earnings crush), making options more expensive. Traders can choose strategies based on their volatility outlook - long vega strategies profit from IV increases, while short vega strategies benefit from IV decreases.

Volatility Skew / Smile

Volatility skew describes the pattern where out-of-the-money (OTM) put options trade at higher implied volatility than OTM call options at the same distance from the current stock price. This creates an asymmetric "skew" in the volatility curve when plotted against strike prices.

The skew exists because investors are willing to pay more for downside protection (puts) than upside speculation (calls). This reflects the market's greater fear of large downward moves than upward moves. The skew is typically steeper for shorter-term options and varies significantly across different asset classes.

Trading Implications: The skew creates opportunities for risk-reversal trades, where traders sell OTM calls and buy OTM puts at the same distance from the money. These trades can be profitable when the skew normalizes. The skew also affects option pricing and strategy selection - deep OTM puts are often overpriced relative to their theoretical value.

Reading Options Chains

Options chains display all available options for a particular underlying asset, organized by expiration date and strike price. Understanding how to read these chains is crucial for making informed trading decisions.

Key Columns:

• Bid/Ask: The highest price buyers are willing to pay (bid) and lowest price sellers are willing to accept (ask)
• Open Interest: Number of outstanding contracts, indicating liquidity and market activity
• Volume: Number of contracts traded today, showing current market activity
• Delta: Sensitivity of option price to underlying price changes
• Implied Volatility: Market's expectation of future volatility
• Theoretical Value: Fair value based on pricing models

Liquidity Assessment: Look for options with high open interest and volume, tight bid-ask spreads, and regular trading activity. Liquid options are easier to enter and exit without significant slippage. Generally, at-the-money options and those near expiration have the highest liquidity.

Expiration & Assignment Mechanics

Options expiration occurs at 4:00 PM Eastern Time on the third Friday of the expiration month. For American-style options, the holder can exercise at any time before expiration, while European-style options can only be exercised at expiration.

Cash vs. Physical Settlement: Most equity options are physically settled, meaning the underlying shares are delivered upon exercise. Index options and some ETFs are cash-settled, with cash equal to the intrinsic value being exchanged.

Early Assignment Risk: Short options can be assigned early, particularly when they're deep in-the-money or when the underlying pays a dividend. For calls, early assignment often occurs just before ex-dividend dates when the dividend exceeds the time value remaining in the option.

Managing Expiration Risk: As expiration approaches, gamma risk increases dramatically, making positions highly sensitive to underlying price movements. Traders should consider closing or rolling positions before expiration to avoid last-minute assignment surprises and to capture remaining time value.

Greeks Interplay at Expiry

In the final week before expiration, the Greeks undergo dramatic changes that significantly impact option pricing and risk management.

Gamma Explosion: Gamma, which measures the rate of change in delta, increases exponentially as expiration approaches. This means that small movements in the underlying asset can cause large changes in option prices and position deltas. At-the-money options experience the most dramatic gamma increases.

Theta Acceleration: Time decay accelerates rapidly in the final days, particularly for at-the-money options. This creates a "gamma-theta trade-off" where the potential for large gains (gamma) comes with the cost of rapid time decay (theta).

Practical Adjustments: Traders often need to adjust positions more frequently as expiration approaches. This might involve rolling positions to later expirations, closing positions to capture remaining value, or hedging with the underlying asset to manage delta risk. The key is balancing the desire to capture gamma profits against the cost of theta decay.