The Anatomy of an Option

Let’s face it. Traders want to make money – the kind that can give them the lives of their dreams. But when it comes to the stock market, there is one fear plaguing people’s minds…

That’s risk.

But the truth is you can actually trade with lower risk and make more money – all with the flip of a switch.

And that switch? Options.

They allow you to rake in unlimited profits without risking a penny more than you put down on the trade. And they have the power to return some of the fastest cash you’ve ever seen.

I’m talking 50%, 80%, 100% or more – all in under a week.

It doesn’t matter if you’ve been trading options for years or have never even heard of them until now. Today, I’m going to show you why you never need to buy and hold single shares of stock ever again.

In this series, I will break down the wonderful world of options – and leave you with a foundation to realize the fantastic benefits of option trading.

Let’s get started…

First of all, there are two types of options: calls and puts.

A call option gives you the right to buy a stock at a particular price (strike) until a particular date (expiration). Buying a call is bullish. If the underlying stock goes up, calls increase in price.

A put option gives you the right to sell a stock at a particular price (strike) until a particular date (expiration). Buying a put is bearish. If the underlying stock drops, puts increase in price.

So, once you know where you believe a stock will go – up or down – the first thing you need to do is pick an expiration date and a strike price.

Strike Price: Agreed to Buy or Sell Price
Expiration Date: Date Option Expires

This information is contained in an option table. These can be found on your options broker platform and on various free websites.

Here is an example of an Option Table for Apple Inc. (NASDAQ: AAPL). The expiration date shown is November 15 with AAPL trading at $240.

You can see that the table has calls on the left and puts on the right. Strike prices are down the middle. For APPL, the strike prices are in $2.50 increments. These increments vary by stock.

The Bid is the sales price of the option, and the Ask is the purchase price of the option. So, for example, the November 15 AAPL $240 Call would cost you $7.05 – the ask price. If you were to immediately sell the same option, you would get $6.85 – the bid price.

The difference between the bid and the ask is called slippage, the amount you essentially need to make back in order to break even on the trade.

It’s important that you don’t put yourself into too big of a hole, so be sure to keep your slippage <= 10%.

To calculate slippage, use the following formula:

Slippage = (Ask – Bid) / Ask

So, in the case above, slippage = ($7.05 – $6.85) / $7.05 = 2.8%. Well below 10%!

Remember – a successful trader is a rules-based trader. Avoid any options that don’t satisfy this rule.

Now, there are a few terms to know when navigating the option table that will lead to another important rule.

Calls Puts
At-The-Money (ATM) Strike = Stock Strike = Stock
In-The-Money (ITM) Strike < Stock Strike > Stock
Out-of-The-Money (OTM) Strike > Stock Strike < Stock

In the option table above, the ATM options are shown with blue text. That’s an easy one! With AAPL trading at $240, the ATM strikes for both calls and puts are $240.

The ITM options are shaded in grey. The OTM options are un-shaded.

Notice that ITM options cost more than OTM options and get costlier as you go deeper ITM. The inverse is true for OTM.

Now that we’ve established some terminology, I can reveal a secret only known by the pros…

OTM options double faster than ATM or ITM options.

Furthermore, the doubling “sweet spot” is generally just a few strike prices OTM.

That leads me to an important rule to maximize your profits when selecting options:

Fastest Double Rule: Buy options 1-2 strikes OTM

Now that you know how to spike the best strike price in an option table, you need to know which expiration date to pick.

This one’s simple:

Expiration Date Rule: Buy 60-90 Day Options

The reason for this has to do with time decay – but we’ll save that for later.

With these simple rules under your belt, you are now equipped to navigate option tables like the pros!

In the coming weeks, I’ll tell you even more about the anatomy of options. If you want to know about implied volatility, the Greeks, shorting, and more, then stay tuned…

I’m going to give you everything you need to become an expert on options in no time.

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Good trading,

Tom Gentile

America’s #1 Pattern Trader

12 Responses to “The Anatomy of an Option”

  1. I agree with you about making money. However I have not been able to learn how the spreads and credit and Debit options work. I always have a feeling that I am leaving money on Table. Where do we get this training. You are not providing this with your minute videos. Tell me where to get this information . reference….

  2. Thank you so much fot this insightful explination on the anatomy of an Option. The only thing I”m not certain of is this. If a option is losing (and it does happen) using your example, how much of real money would you be paying or have to have in the bank?

  3. Your breakeven is much more reasonable with an ITM call. The price you pay for the bigger double is a need for a large upside move. You are prescribing more risk for more reward, good for volatile markets.

  4. My brokerage house only gave me level 2 clearance because I have no opinion experience and all the trades on Alpha 9 require level 3. Will simulating trades account for experience or can you offer level 2 suggestions that have no greater risks than the ones you give that are level 3?

  5. Angela B Longhurst

    Thanks for the training it was very informative for me because when it attempted to buy options on my TD Brokerage account everything look like a foreign language wasn’t sure what I was doing. Now I know a little more than before. I still feel like a fish out of water. Thanks for the insights.

  6. Thank-you for the lesson! So basic yet so hard to learn or find or figure in all the hype from marketing us “retail” investors. I don’t know about the rest of you but the inundation of marketing emails after you sign up for these types of subscriptions only add to the confusion I’m trying to overcome by learning how to profit from the markets on my own.

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