If you are going to trade stock options, one of the most important tools is the Option Chain. The COUNTLESS values in the Option Chain can make it look intimidating, but luckily there are only a few key numbers that matter.
BID and ASK are the price points that you can buy an option or sell an option. Buy at the ASK and sell at the BID.
The price difference between bid and ask is called the SPREAD. If the spread is too wide, then the option price will need to move the amount of the spread before you break even on your trade.
Unless you are trading a high-priced and highly volatile stock, the spread should not be more than 25-35 cents. Of course, this depends on the stock you are trading. If the stock normally has a 50-cent spread and moves $7 a day or more, that spread can be acceptable. Get to know your stock and the normal spread amount in the option chain.
THEORETICAL VALUE or FAIR VALUE is what that option would be in normal conditions. (If we only knew what “normal” is in the market). There is a formula called the Black Scholes Model, but even most calculus courses do not cover that.
Use a rule of thumb to not trade an option that is greater than 20% of the Theoretical Value. Think of it as buying a pair of jeans regularly priced at $50 for $75. If it is overpriced, then don’t buy it. Selling overpriced premium, however, is an excellent strategy.
INTRINSIC VALUE is the amount that particular option strike is ‘In The Money’ or the physical worth of the option without time value involved. Depending on the strategy, you might desire to have Intrinsic Value to be greater than time value when buying.
OPEN INTEREST is the cumulative number of contracts that are open at that particular strike price and time frame. Typically, you want to be at the largest party so that buying and selling is easier. WealthBuildersHQ teaches you to make sure there is at least 100 open interest and that you do not own more than 10% of that open interest.
VOLUME shows the current day’s contract trading activity on that strike price. This is option contract volume and not to be confused with stock volume.
DELTA is a measure that approximates the movement of the option price in comparison with the stock movement. Delta increases and decreases as the stock moves, so it is not static. Robert Roy prefers a Delta of 65 or greater when trading a directional strategy.
THETA is the rate at which an option loses its value. Theta decay (or time decay) increases or speeds up the closer the option gets to the expiration date. Many traders like to hedge theta decay on long options by creating a spread. It is still important to know how fast your option price is losing value.
GAMMA is like an accelerator in a car. If Delta measures speed, Gamma measures its rate of acceleration. Gamma is how fast Delta changes as the underlying equity moves. There is a sweet spot for Gamma and getting the best move on your option.
Implied Volatility is a future forecast of the predictability of a stock at different strike prices. Implied Volatility is in options only. Volatility of stocks is measured by Beta.
With these values in your option chain, you can gather a great deal of information to make a good decision on which option strike position to buy or sell.