How to Use "the Greeks" in Options Trading

Many investors shy away from options because they seem too complicated or risky. The truth is that options can be quite simple and straightforward to use.

And they can even be part of a conservative investment plan.

That's right, a conservative investment plan.

No doubt, there are a lot of jargony terms in the options world. But there is no need to fear them.

In fact, knowing just a couple of these words could help you hedge your existing portfolio - or even make a small fortune if you decide to "swing for the fences."

Let's go over the most important terms for beginning options traders. The important point to remember is that you are not trying to scalp every last cent out of your trade. Rather, you are looking to make a difference in your investment success.

Here we go - we'll start with the big four that you must know.

The Big Four Options Trading Terms

Type of option - There are two types of options: "calls" and "puts." Calls give the holder the right, but not the obligation, to buy the underlying stock at a specific price by a specific date. Puts give the holder the right, but not the obligation, to sell the underlying stock at a specific price by a specific date.

Strike price - The strike price is the specified price at which you can exercise the option. For calls, if the strike price is above the current price of the underlying stock, then it is "out of the money." If it is below the price of the stock, then it is "in the money." For puts, it is the reverse.

Expiration date - Also called the "exercise date," this is the date at which the option becomes null and void. It will either be in the money, in which case it is automatically exercised, or out of the money, in which case it expires worthless.

Premium - This is the price the buyer pays for the option. It is not the same as the money needed to exercise the option.

Whether you already knew these or you are a beginner, a refresher can only help. Now, let's move on to the "Greeks," which are essentially derivatives of the big four.

You might know these as some of the more jargony terms in options trading. But they can all make sense together once you realize one simple thing...

The Options Trading "Greeks" Made Simple

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Simply put, the "Greeks" describe how an option behaves.

These are labelled with Greek letters, such as delta and theta. They tell us how fast an option price moves based on time to expiration, interest rates, and how in or out of the money the option is.

Needless to say, these numbers can be useful in planning your trades. But you don't need to get too deep into the weeds with them. A basic understanding of what they do is really good enough.

And just to show you that what is more important than their names or calculations, we'll list them here by what they mean for you and your investing.

Sensitivity to stock price movement (Delta) - The more "in the money" an option is and the closer it is to expiration, the more the price of the option moves in lockstep with the price change of the underlying stock.

Time decay (Theta) - Options naturally decay in value over time. The farther away from expiration, the more time value in the option. But that value declines every day. In short, the more time your option has to get in the money, the more valuable it is.

Intrinsic value - While there is no Greek letter here, intrinsic value tells us how much the option would be worth if it expired today. It is a measure of how much the option is "in the money" or "out of the money." Put another way, it is the difference between the underlying stock's price and the option's strike price.

Out-of-the-money options, where a call option strike price is above the stock's price or a put option strike is below the stock's price, have zero intrinsic value. Any value they carry, i.e., a price above zero, is based on time left to expiration.

The higher the stock's price is above the call option's strike price, the greater the intrinsic value. And the converse is true for puts - the lower the stock's price below the strike, the greater the intrinsic value.

Volatility (Vega) - Options are also sensitive to changes in volatility. The more volatile the underlying stock, the more an option will cost, because it is more likely to expire in the money. Interest rates also factor in, but for our purposes, we can set them aside. In other words, an option on a big tech stock is going to cost more than an option on a utility stock, simply because the former moves around a lot faster.

That's really it. Knowing how an option will behave based on its strike price, expiration, and type will put you on the road to your first options trade.

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