Introduction to Options

Stocks are suitable for holding to gain company profits and dividends. If you want to make money in the market in the short term, you can choose options trading, which offers more opportunities to earn money.

Steps to buy options:

  1. Choose the underlying stock.
  2. Choose the options strategy.
  3. Choose the strike price.
  4. Choose the expiration date.

Choose the Underlying Stock#

Choose an underlying stock that you are familiar with. Additionally, choose a stock with high trading volume.

The reason for choosing a stock with high trading volume is liquidity. Stocks with high liquidity are easier to buy or sell options for. If a stock has low trading volume and poor liquidity, even if you hold a valuable option, it will be difficult to sell at the desired price.

Choose the Options Strategy#

There are two concepts here: Implied Volatility and Historical Volatility.

Implied Volatility is mainly used to quantify the market's expected volatility implied in the option price, reflecting the market's expectations for the stock.

Options with higher Implied Volatility are more expensive. Both call options and put options are affected by this. Higher volatility indicates a higher likelihood of price increase or decrease, resulting in higher option value.

I don't quite understand why higher volatility leads to higher prices. Because the name "volatility" doesn't reveal whether the stock is likely to rise or fall. Why does higher volatility mean higher prices?

In fact, options are a form of insurance.

Let's take a real-life example. If you are older, the price of buying medical insurance will be higher because the probability of you getting sick is much higher than that of younger people.

Now, let's look at a call option. If I buy an option from you to buy BTC at $6,300 the day after tomorrow, you can interpret it as me buying an insurance policy. This policy guarantees that I can buy BTC at a price of $63,000 the day after tomorrow.

Therefore, if the probability of this event happening is higher, the price of the insurance policy will be higher. If the probability of this event happening is lower, the price of the insurance policy will be lower. If the market price exceeds the strike price I set, the policy will become more valuable because the excess amount is considered profit.

In an ideal situation, it is suitable to buy options when Implied Volatility is low and sell options when Implied Volatility is high.

Historical Volatility serves as a reference point. Its purpose is to help determine whether the current Implied Volatility is high or low.

  • If the current Implied Volatility is higher than Historical Volatility, we consider the current Implied Volatility to be high, and the strategy leans towards selling options.
  • If the current Implied Volatility is lower than Historical Volatility, we consider the current Implied Volatility to be low, and the strategy leans towards buying options.

Choose the Strike Price and Expiration Date#

The value of each option can be divided into two parts:

  • Time value
  • Intrinsic value

Let's explain this concept with an example. Suppose, under the following conditions:

  • I am bullish on BTC.
  • I believe it can reach $62,500 in one week.
  • The current market price of BTC is $63,000.

Now, I want to buy a call option for BTC at $62,500 one week from now. How much does this option cost?

  • The current market price can be sold for $63,000. If I want to buy this option, I have to pay $500. Otherwise, who would be willing to sell you this insurance?
  • At the same time, I also need the seller to wait for me for a week as I will exercise the right later. Therefore, I need to pay a premium for this one-week period. Let's assume it is $10.

I need to spend $510 to purchase this option.

Based on the above definitions and explanations, we can easily conclude:

  • As time passes, the time value will gradually decrease.

    It is easy to understand that the longer the time until expiration, the more time there is for price fluctuations, and the more likely it is to reach or exceed the strike price.

    The shorter the time until expiration, the less likely there will be price fluctuations, and naturally, the lower the value.

    As long as you hold the option, the time value will continue to decrease, and the option will continuously depreciate.

  • The closer the strike price is to the current stock price, the higher the time value. This is because the closer it is, the higher the probability of reaching the strike price, and the remaining time is limited. Therefore, the time value will be very high.

  • If we rely on intrinsic value to make money, there is still the risk of misjudgment, where the option does not reach the strike price or moves further away from it.

This is the risk point of options trading. Time value will pass, and if there is a misjudgment in the intrinsic value, the option will become worthless.

Returning to the selection:

  • Since time value will continuously pass, naturally, we hope to choose options with a lower proportion of time value.
  • Try not to choose options with strike prices close to the current price. Because the time value is high, it will depreciate quickly as time passes.
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