Basics Of Options Trading Explained

Okay, hello and welcome, and I've got with me a special guest today. We get a lot of questions here at Amplify Trading about trading options, and I wanted to get a specialist on, and I can't think of anyone better for that job than Imran. So hello, Imran, how are you doing?

Hey, Anthony, how's it going?

Yeah, good, good. I'm, uh, I'm excited to have you with us because I know that you spent a career essentially working in this space. So why don't you just introduce yourself and give the guys a bit of a backstory of how you arrived here at Options Insight?

Right, thanks. Um, yeah, so my name is Imran Larka. I've been a trader for around 20 years. I started my career in, you know, the big investment banks, so Credit Suisse back in 2001, so a long time ago. Then I went to Merrill Lynch, traded through the financial crisis over there in 2008. And then spent a bit of time at Citibank running their index, European index desk over there. I had a short stint at the buy side as well, Bluecrest Capital, and now I run my own training firm where I teach investors, asset managers, pretty much whoever wants to, how to utilize options to improve their trading and risk management.

Okay, great. I mean, look, very illustrious background. So it's great to have you with us. And, um, yeah, I'm just interested to know then, and I want to accommodate everyone of different levels of expertise. I know obviously that a lot of our US community a little bit more familiar perhaps with options, particularly in the equity space. But I think for 2020, it's obviously been a pretty exceptional year. But I know having spoken to you before you were talking about how its options has provided a unique opportunity in a certain sense, different to say outright positions or the futures market.

Yeah, so I mean, it's been a crazy year, clearly some, some very wild moves happening in all asset classes. And the thing that really struck me was that usually you get maybe one or two occurrences a year where you get to use options and they give you crazy payouts of, you know, more than 10 to 1. So you might spend X amount of premium on option and the payout will be 10 times what you paid. But I mean, the ridiculous thing about this year has been there's been probably 100 to 1 payouts on options, and it's happened for, you know, probably 5 times from just what I can remember and what sort of stuff I've been trading and looking at. But so that's what makes this makes this year really unique. And, and I, I took a bit of a step back myself from trading probably 2 years ago, and I was compelled to start trading again this year because once I saw what was happening in February and the, the tail risk that was emerging in coronavirus, I was like— I said to my wife, I said, you know what, I think I'm gonna have to put my trading hat back on because you don't get opportunities like this every year. They're like more like once-in-a-decade type opportunities. So that's what I did in March, and I kind of put my trading hat back on, sat in front of the screen every day and just had fun, actually. I know it sounds a bit weird, but for options traders, volatile markets are a dream. And, you know, once you know how to utilize them, it makes your trading much more interesting, exciting, and dynamic, basically.

Well, I mean, I'd love to get down into a little bit more the detail of examples, but perhaps before doing that. A little bit of just understanding about some basic option concepts would be, would be great for everyone, I think.

Sure, yeah. Okay, well, I'll share a couple of sort of slides and we'll just go through the basic options that exist. So the two most basic options that exist, they're called vanilla options, and they are called calls and puts. And You can see the slide up here. So that's a call option, right? So what is a call option? It is the right but not the obligation to buy an underlying asset, you know, which is— let's call it a stock, um, or an index or a commodity, whatever it may be— at a fixed price, which is called the strike price, at a given maturity, which is called the maturity date. So, so unlike trading futures or stocks, which are just sort of linear payoffs where you buy it, if it goes up, you're making money, if it goes down, you're losing money, and it's one for one in terms of, you know, how much you make or lose. Um, look, these are non-linear payoffs, right? Because you don't have to buy it. So you've got the option to buy it. If, for example, this, this thing is 100, this stock is 100, if you buy a call option struck at 100, you have the option to buy that stock at 100, but if the stock goes down and it's cheaper than 100 at expiry date, you don't have to buy it, which is why the payoff doesn't actually go below zero. If you look at the blue payoff, that, that kind of hockey stick, as it's known as, that doesn't go below zero when the stock price is below 100. And if it's above 100, then you will— the payoff will be the same as had you bought it at 100. Now, to have this amazing payoff where you can't lose any money, obviously you have to pay a premium, right? And that's, that's the thing about options, like they do, they do cost you something to have them. Otherwise, you know, it wouldn't make any sense, like no one's going to give you that asymmetric payoff for free. And the premium that you pay, in this case I've said the premium of that call option is 5, and in this case you pay 5. So the true P&L of that position if you were to put that trade on, pay 5 for that option, at expiry, if you kept the option all the way till expiry, then depending on where spot is, your P&L would be the green line. So that's where you shift that payoff down by the premium. So that's, that's a call option, you know, which is the option to buy the underlying. But the good thing is you can also have options to sell the underlying, and these are put options, very, very commonly used in the options world. And same story, they're just the mirror image. So this time, you know, I've got an example of being able to sell the underlying at 100. You have to pay a premium again, which is why the green P&L line is shifted down. These are bearish positions, right? So if I was to buy a put option, then I'm bearish on the asset. I think it's going down, and that's where my payoff's gonna come from. And these are used usually as some form of insurance, right? Because the general, sort of investor community is long exposure to, let's say, equities or whatever. And they might be a bit nervous about the macro landscape, they might want to protect themselves, and they're willing to pay that premium for the put option as like an insurance premium. And if the market then was to go down, they might be losing on their asset portfolio, but their puts are actually increasing in value and providing them some protection, right? So there's a very— that's the most common use of put options as protection. To a portfolio. So those are the basic kind of payoffs and what options are, basically.

Okay, well, that is the— yeah, so what, what are the— yeah, these are the benefits then that you— I can see you've got out outlined, the benefits and risks, I guess.

So the next sort of slide just talks about why do you use options. And so The major benefit of using options, and this applies particularly for retail people, is that you get, you get great leverage, right? So you might not have loads of money to play with, but if you, you can spend that small amount of premium, and if you happen to catch a move in the market, then that premium can multiply by 10, 20, even 100 if you get really lucky, right? So, you know, in the, in the case of you know, recent times in March or February, let's say, had you spotted what was going on in China and you thought, you know, this is a terrorist to the market and we could really— this could get out of control, you know, you could have bought S&P put options for pittance, right? And within the space of 3 or 4 weeks, you know, they had multiplied by 100, which is crazy, right? But that's what you could do. Yeah. Um, the good thing also is that when when you spend a premium and that's it, you know you can't lose more than the premium that you spend. So whereas, you know, in trading you have to think a lot about where to place your stop losses and your risk reward and stuff like that, the beauty of options is that they automatically tell you what your risk is. It's the premium that you spend, right? And you know what the expiry of the option is as well. So you know that I spend that premium, that's what I can lose. The option doesn't die until a month's time or 3 months' time, whatever you've, you've, uh, whichever expiry you've chosen. And, and then you don't have to worry too much about some freak move stopping you out and then you being right in your view and not making money. I mean, that's the worst feeling in the world for a futures trader. I think we've all experienced it. We pull our hair out, like, how do we avoid that happening? And there's, there's techniques and ways to do that, but options are a great way because you can say, you know, I know, I know I can only lose X, but, you know, I've got this trade on for 3 months, got plenty of time for my view to play out. And, and it's quite a nice way of sort of managing your risk. And I'll put lottery tickets there as well. I mean, you can, you can trade very, very far out-of-the-money options, which means that the strike price is so far away that the premium of the option is really next to nothing. And you can consider these as lottery tickets basically. So if you were to, you know, get some random tail event happen— for example, silver was a good example recently when silver started breaking out, you know, you could have had some really like 30% out of the money call options which were priced very low, and you know, you saw a 40% move in a matter of weeks. And in silver. Yeah, yeah.

Was there something similar happening with, uh, Tesla when Tesla, what, about a month, two months ago was shooting higher? And I saw some crazy calls in terms of option plays going, um, at the time that were, I thought, ridiculous.

But yeah, that's right, I remember which strike were they buying. It was, um, I think it was like a one-week 2000 strike, so I don't think those options paid out in Tesla. The bonds that you're talking about. But yeah, people— exactly, that's what people are doing, right? They're looking for those lottery tickets because they're thinking this is the type of stock that could be up 20% overnight, and right, you know, I don't have to pay a lot of money to get exposure to that. Yes, the chances are it's not going to make me money. That's why it's priced cheaply. But, you know, in the year that we're experiencing, crazy stuff's happening, and those lottery tickets are paying out a lot more than they would in a normal year. I mean, you've got to be careful, right? I mean, the paying— buying options and buying lottery tickets and these great payouts, they're very seductive, and they make you want to basically buy options every day. Yeah, because what could happen? So you have got to be careful about how often you buy options because they do usually expire worthless, right? That's the— so the premium does decay. You spend X for an option, and then over time that premium decays, and they do lose their value. So you do need to be a bit selective about when you buy options. And, you know, there are various ways to figure out whether options are expensive or cheap or worth buying. And that's kind of— that's about understanding the factors that affect the price of an option, such as things like implied volatility. And when implied volatility is fairly priced, whether it's cheap, whether it's expensive, that, that will deter you from buying For example, silver now, right? Silver probably trades on a 60 volatility now, an implied vol of 60, which, you know, is, is kind of implying that silver is going to move 4% a day roughly. And, but, but a month or two ago, silver might have been on a 30 vol, which is saying it's implying it's going to move 2% a day, right? So there's a big difference between those two things. So, you know, you're going to be much happier about spending premium on optionality that's pricing 2% a day move on an asset because when, when the asset does go crazy, the market's going to reflect that in the way it prices its options.

So things like implied vol and monitoring that, is there— if you're a retail trader, how do you get visibility of these types of—

you do have platforms that allow you a bit of that. So you've got Interactive Brokers, probably the best one. You've got, you know, you can trade a whole host of options on there because they just trade directly on the exchanges. So it's not CFDs, it's actually trading the options on their exchanges. And they've got some analytics as well which shows you what the vol surface looks like, what it's been doing, that kind of thing, right? So I think that's the best, probably the best platform around to trade options that I'm aware of.

Okay, so if you were, let's say, if you were someone completely new to this, this arena and you've never traded options before What's like the general kind of path of progression that you would recommend for someone coming at it at a retail sense? Like how, you know, you mentioned about, obviously you can calculate what are the better opportunities to be more selective, but as you say, you can be seduced almost. And I'm sure that's the biggest hurdle for a lot of people new to it is I'm sure they get drawn in because they hear about the media loves to pump it, obviously, when when it works out well. What would be a controlled or structured way of getting to the point where you can identify with better selection?

So I mean, look, I think first of all you need a basic level of education and you need to understand what option payoffs are, how option premium behaves, all those things. Obvious place to learn that is me. Yeah. So, you know, I provide, I provide training courses and, you know, I've got a big syllabus in options and and my focus is on teaching people to trade options intuitively, right? So I don't use, I don't use textbooks, I don't, I don't throw a load of formulas at you. I teach you why the premium is what it is and how it evolves through time and how it evolves through space, like I spot, yeah, and the considerations to think about what, what option structures make sense in what volatility environment. So for example, VOL's cheap, I'm going to buy an outright call option if I'm bullish. VOL's not so cheap, I might buy a call spread so I don't spend as much premium and I don't buy as much volatility in a call spread. And obviously I won't go into details what that means. And then another option is actually vol's super expensive but I'm still bullish, I'll buy a call ratio where I'll actually sell volatility but I'll have a bullish payoff profile and I'll have a various expectation of how much the asset can rally, right? right? So there's all sorts of funky structures you can do within options space that allow you to take advantage of your opinion and your view of where vol is versus what it should be and the scenarios of the asset that you're trading, right? So, so get a basic level education and then also, you know, once you're an options trader and you know what's going on, that doesn't mean that you can predict with precision what the market's going to do every time. So what I say to all my students is, you know, split up your implementation, right? You might be bullish on it on a trade. I'll give you an example. Recently, euro threatened to break out on the upside, like 1.1950. And you know, there was a half-decent likelihood that it was going to go to 1.25 if it broke, right? So, you know, what did I do? I said, right, if it breaks, it's got legs to 1.25 potentially. I don't know if he's going to manage it. I don't know if it's going to do it quickly, slowly, or whatever. So I bought some outright spot with a stop at 118.5, yeah. And then I bought— so I decided how much I'd be willing to lose on that delta part of the trade. That's a delta one expression. And then I said, with the other part of the trade, I'm just going to buy some call options that expire in September, in a month, and I'm going to spend X amount of premium on those. So then I've split up my view and my expression by in two different ways, one with optionality and one with just straight delta. Right. So that's the way to think about it. Right. So, you know, spread your bets in a way that your view's the same, but you don't have to implement it in just one form. If you, if you implement it in a couple of different ways, then you expose yourself to the different scenarios where, you know, euro might have had a false break, come back to 118 and a half, and then gone to 125 over the next 3 weeks. And I would have been grateful that I didn't just do it all in Delta. I did some in options, basically.

Yeah, but in this— in that example, then you would still be— I mean, obviously determining the overall origination of the idea is looking at the global macro environment, or what is that underlying the actual technical setup of that particular asset or product in question.

Yeah, and the vol was cheap, right? The vol was 8.5, right? So, you know, euro FX vol does tend to trade quite low. So if you think there's a trend about to— if you think there's a break about to happen, usually the implied vol hasn't priced that much for it. So because the implied vol trades on the kind of daily expected move, right? Because the person who sells you that option is going to hedge that option in it, and if as long as it doesn't move more than 50 bps every day the option seller won't lose money. But when you buy it, you're not hedging that option. You're just buying it, spending the premium, and then coming back in a month to see where we're at, basically, right? So that is a situation where both the seller— if it's a steady rally of 50 bps every single day, but we get to 125 in 2 weeks, the option seller doesn't care because the volatility hasn't been so great that he's lost money on his, on his Greek positions, right, on his risk management. Whereas the option buyer's done okay because he's run that trend and the option value has just increased as we keep going. Yeah, right. So there are times where the option expression isn't the right one. So another example would be, let's say we do get the rally to 1.25 on euro, but it's too slow, so the option never really gets in the money because you might have traded an out-of-the-money option, 1.22 strike, and it never quite gets there or doesn't get there fast enough, so the premium's just decaying as you go there too slowly. Whereas just buying the spot at 119.5 is making you money. So that's the advantage of splitting your expression and giving yourself a lot more scenarios. And hopefully at least one of them— sometimes both of them will work, but then, you know, you're trying to increase the odds of at least one of them working.

Yeah.

So let me— I know you have some good examples of so far in 2020, but for the for sake of time, if you were to pick one isolated situation which has happened so far this year that was particularly played out well for a setup that you foresaw, what would that situation have been? Is there one that stands out in your mind that was—

I mean, I think there's probably two. There's two that stick out. There's, um, so once you had the sell-off, the original sell-off on corona on the S&P and the broader equity market, and then you had that bounce when they cut rates initially in the US. So there was a clear setup for me in that, and I was putting videos out about this and I was saying that, you know, it was— for anyone who thought about it, it was obvious that a 50-bit rate cut or whatever they did was not about to change anything, right? They had to do a whole lot more to fix what was about to go down, right? So, so for me it was like, I, I obviously want to own S&P puts, okay? But the problem was, you know, historically owning S&P puts has been a losing trade. The vol had already repriced from, let's say, the teens to maybe 20, 30 kind of levels, right? Because they already had that original shock. So it's like, what do you do? So for me, I was convinced that there was no way we were going back through hot, close to the highs on the S&P in the short term, right? Because I was like, you know, this thing has just started. You know, we're going to see all the repercussions, we're going to see all the dominoes falling. So the way I traded that in options space was I said, right, I'll buy the S&P puts struck at 2,400, 2,500. And the market was trading at 3,000 and a bit, let's say, and I was funding those puts by selling upside calls, which were 3,250, 3,300 kind of area, right? Because I was super convinced that those calls are never gonna go in the money. I'll collect premium from those calls and spend that premium on the puts. Because then if nothing happens and we just kind of chop around trying to figure out what's happening, I won't lose any money. If we melt down, then obviously I go towards my puts and I make loads of money. And the only scenario where I really take some pain is if we smash back through 3,300, which was very close to the highs in February. And I didn't think that was a— that was— I didn't think— I thought that was such a low probability outcome, um, to happen so soon after the crisis. So I was saying like April and May, April and May call options struck in that area basically as my funding leg. So that was a great trade and that was a great setup. And, and it, you know, thankfully for me that worked out well. Um, and then the other, the other probably most obvious one has been the, the gold breakout, the recent gold breakout, right? So, you know, you've been looking at a price action on gold for the last year. It would have its leg up and then it would consolidate for a while, break, and it would take another go, right? And so that price action was— it just kept happening. It was quite predictable and as long as you're patient and you wait for that break to happen, then all you had to do was like, for example, that break of $1,850 on like the 21st, 22nd of July. That was, that was the break level, right? You look, you looked at where the, where the highs were when it took out around $1,820 to $1,850 in gold. That's your cue to just buy a load of upside calls, right? Because the vol wasn't that expensive. The vol was in the high teens, I believe. And yeah, you can buy— and I put a video out about that actually. I think it's on my YouTube channel, Gold and Silver Breaking Out. I basically discussed with a group of students what ways could we use to play this gold breakout. And we're saying you could use outright calls, you could use call spreads, look at the payoffs, look at the risk-reward, which one do you want to do, and what the pros and cons were of each expression basically. But that was probably one of the easier ones of late.

So I think, I think something that people would find valuable in terms of your insight is, you know, given the way that macro themes tend to be fairly channeled, I guess, in a way, in that we know as a milestone certain events are happening. We have things like a kind of a tentative, almost early deadline for Brexit to be delivered before transition at the end of the year coming October. But then let's focus on the US election. We know when that is happening, and we know that the the coronavirus is going to impede the ability for the immediacy of results to be known, and people are already anticipating multiple week delays, and that, that will probably increase uncertainty. Is there anything in preparation of that then that can be done now, and/or at what point in the future does that then start to channel a lot of the options activity, just more broadly speaking?

Yeah, it's an interesting question. I mean, The, the biggest thing on, on the US elections is, you know, the VIX curve has been kinked for the US election for, for months now, right? And I, I, I put out a little thing on LinkedIn explaining to my students how you can extract the implied move on the S&P from the kink in the VIX curve, right? So last time I looked at it, it was kind of implying roughly— and it's a crude approximation, basically you're making the assumption that the kink is completely due to one day gap on the election day, and without that, the curve would be smooth. Okay, so it's a, it's a crude assumption, but, but it gives you a sense for what's being priced. So that was coming in at roughly 4.5-5% move for the election day, uh, versus like every other day being a normal move, which might be like 1.3-1.4%, something like that, that the VIX was pricing. Yeah, so that's one way of looking at it and monitoring what the bull market believes about the election and the risk attached to the election, right? So you could track that implied move for the last 6 months and see how much that implied move is moving around, right? People are getting nervous or complacent about the election risk.

And is the market complacent about the Brexit risk at this point in terms of—

yeah, I think the problem is the market's just tired of Brexit, right? I think we're Brexit was first around in 2016, the market wasn't complacent. It was pricing a lot of risk.

Yeah.

And, you know, you know, it was certainly pricing a lot of tail risk, and then you saw that on cable moving 20 big figures on the, on the day, right? But, but that was when it was all fresh in our minds, and it was, oh my God, oh my God, what's going to happen? This has dragged on for so long now that, yeah, I think the market has kind of stopped paying attention to an extent. And you, you look at where cable is 132, it doesn't feel like the market's that nervous about it.

Yeah, yeah. I mean, for me, even, even though I'm not looking at options in the same way you are, I would say it still forms part of what would be my opinion of what I think an overall outcome. So thinking as like a political strategist, what do I think in that regard? What do I think about then the risk economically for the players involved, like Europe and the UK? I think about all these different things, but that is definitely like what you said, the price, just the actual price of where we're trading at 132 is reflective of where the feds are at. And also you get the options noise start coming out, but the fact it's so quiet is really quite telling.

But I think the easiest place to see what the options market is signaling on Brexit is to look at the skew, right? So if you look at what the 25 delta risk reversal on cable looks like, where that's been relative to history, that gives you a barometer of Brexit risk. I don't know where that is. I haven't checked it myself, but that would be the thing to look for.

Yeah, cool.

Well, look, let's, let's wrap it up there.

Thank you so much for that insight. It's just, you know, it's a really fascinating area, and I'm sure there are some people that are quite intrigued by this discussion. And if so, I will put some details Yeah, you'll find all my sort of links—

Twitter, YouTube, my website, etc.— on there. Stick that in the, in the comments or whatever it is.

Yeah, no problem, no problem at all. So Imran, always pleasure. Take care and I'll speak soon.

Thanks a lot, Anthony.