Are you interested in learning what an option chain is and how it works? Then look no further! In this article I will explain how to read an options chain and why it’s important when selling options and following the options wheel strategy.

what is an options chain

What is an Options Chain?

If this is your first time looking at an options chain don’t freak out. From first glance I know it can be a bit overwhelming.

When you look at option chains for different stocks, you’ll realise how simple they are.

As option traders, we use options chains every day to find opportunities to sell puts or covered calls.

An option chain is a list of all call and put options available for a particular stock, index or an ETF such as the TQQQ.

An options chain provides you with important information such as the strike price, expiration date, and the bid and ask prices for each option. These terms will become more familiar the more you read on.

An options chain is a crucial tool for traders who are looking to buy or sell options.

The options chain also allows you to see the implied volatility (IV) of each option. This is important when determining the potential profitability of an option trade.

By the way, if you’d like a free PDF version of everything to do with selling covered calls and puts, you can grab a copy of my Options Selling Roadmap here.

What are the components of an options chain?

For now, just understand that when you wish to sell or buy options, you would typically log on to your account in a similar way to logging onto your online banking.

Then, you will be presented with various information, at the heart of which, will be an option chain.

how to read options chain
Here is a screenshot of Tesla’s option chain within Interactive Broker’s TraderWorkstation platform.

The example above is of Tesla’s option chain, ticker symbol TSLA, taken May 2023.

I understand that at first sight, this might appear daunting (or damn right confusing)!

But once you become familiar with an option chains you’ll realise they’re a logical and straightforward to grasp.

Each stock is associated with multiple options. These options include both puts and calls, each having various strike prices.

Additionally, for each strike price, there are different expiration dates. This results in the grid-like layout you see above, known as an option chain.

The option chain is a logical presentation of the available options for a particular underlying share. Most options brokers and analysis software display options information in a similar format. The example shown here is from Interactive Brokers TraderWorkstation.

Across The Top Of The Chain

Across the top of the screen is information about the underlying share — Tesla in this example. It shows the ticker symbol (TSLA), and the price that the shares last traded at ($179.65).

Calls On The Left And Puts On The Right 

The screen is divided into two halves with the calls on the left (green rectangle around).

The puts are the right (pink rectangle around). You can see the appropriate labels near the top of the screen.

The Middle Of The Options Chain:

The vertical bar down the middle contains the strike prices and you can see strikes ranging from $175 to $185.

At the time of screenshot, Tesla was trading at $183 per share and so the IB platform is displaying the strikes nearest to the current share price.

Note
There are many more strike prices available — they are not displayed in this screenshot.

The Bid And Ask Price Of Options:

Options — like shares — have a bid and ask price. Those are the numbers you can see in the grey boxes and they show the price of the Tesla option in dollars per share.

So, if you see for the July 21, 170 put option for example, the bid price represents $9.45 per share.

And because a US option represents 100 shares, you multiply that number by 100 to get the value of a single option.

For example

In this case, that’s $945 per option contract you get paid if you sell the July 21, $170 put option in Tesla that expires in 58 days. Not a bad premium to get paid if you are happy to buy Tesla at $170 I am sure you would agree.

You might also like: My Guide To Selling Puts To Buy a Stock

Note:
The bid price represents the default price for which you would sell an option. The higher ask price is the default price at which you would buy an option. The difference between the two is called the bid-ask spread.

For each option listed, you will find a bid price and an ask price indicated at the top. In every instance, the bid price is lower than the ask price.

Consequently, if you were to purchase an option at the ask price. Then immediately sell it at the bid price, you would incur a loss equal to the bid-ask spread.

This is because the “market makers” who operate options and share exchanges generate their profits through this spread.

What Does the Black-Scholes Model Do?

What Is The Proximity Component Of An Option Chain?

The proximity of the strike price to the market price determines the next aspect of the extrinsic price.

Generally, options with strike prices close to the current market price of the underlying share will have higher premiums.

But, options with strike prices further away from the market price, given the same expiration date, will have lower premiums.

The crucial aspect to comprehend is this:

When an out-of-the-money (OTM) option has a strike price far from the market price then the chance of it becoming in-the-money (ITM) by the expiration date is minimal. But, this also results in a lower premium.

An option with a strike price equal to the market price holds a 50% chance of ending up ITM by expiration. This assumes an unbiased view on the potential price movement of the stock.

Consequently, it carries more time value (premium) compared to the deep OTM options.

PRO TIP
If you want to compound your account by a certain % each year then you need to pay attention to the premiums. 

Look for stocks that fit your premium goals.

Some safe stocks like Campbell's Soup (ticker symbol CPG) have very low premiums. Whereas stocks such as Marathon Digital Holdings Inc (ticker MARA) have very high premiums.

I like to look for premiums of between 15-25% (annualised).

I would be happy to compound my account each year at this level.

If I do go out on the risk curve a little then I would and have sold cash secured puts on MARA. But when doing so I only use a small % allocation of my entire portfolio.

What Is The Volatility Component Of An Options Chain?

The main component of an option’s extrinsic value is the volatility of the stock.

Volatility refers to how much a stock price moves within a given period. This is regardless of whether it moves up or down.

A highly volatile stock, like a tech company, tends to experience larger price swings compared to a less volatile stock such as a utility company.

Volatility impacts an option’s price. The higher the volatility the more likely the option ends up in-the-money (ITM) by expiration.

If you choose to trade options on stocks that are volatile, then you can expect more juicy premiums.

Conversely, a less volatile stock is less likely to move significantly. This results in lower option value and less premiums.

The great thing about options is that there is a different approach for everyone. I like to sell options against big boring blue chip stable stocks that pay dividends.

When learning to sell options, you have to trade within your risk tolerance and find your own trading path.

The key point to make is that when volatility spikes, so do option premiums 💰

Volatility is not constant and can fluctuate over time. When volatility spikes, option premiums rise as well.

So what causes volatility to rise? Well an earnings announcement coming up causes volatility to increase on a stock. This can then lead to higher demand for put options as insurance during market declines. This then further drives up options premiums.

Note

There's a connection between put and call options with the same strike price and same expiration date.

When the price of put options increases due to volatility, the price of calls are also affected.

What Is Open Interest, Volume And Liquidity In An Options Chain?

There are two important indicators related to options trading: Volume and Open Interest.

These provide insights into the level of liquidity for a specific option. They also help you understand its trading activity.

1. Volume / Liquidity

Firstly, let’s refresh our understanding of what we mean by liquidity. It refers to the extent of trading activity for a particular security.

Higher trading volumes indicate greater liquidity. This results in improved ease of buying and selling options at good prices.

It also helps narrower the bid-ask spreads.

These factors combined influence the speed and ease with which you can enter or exit a position.

Volume is simply a measure of how many of the options have been traded on a given day. The higher it is, the more liquid the options are as there lots of interested parties that day looking to buy and sell contracts.

2. Open Interest

Open interest represents the count of active contracts currently in circulation.

It’s important to note that an option contract is generated when it is initially sold or written. This leads to a gradual increase in open interest over time.

However, the number of contracts decreases when they are exercised or offset by a “buy to close” trade.

So, open interest includes all contracts ever created for a specific strike price and expiration, that have not yet been closed.

Higher open interest indicates a greater number of existing contracts reflecting increased interest in a specific option and increasing its liquidity.

Additionally, trading volume of the underlying shares provides an indication of option liquidity. Shares that experience a high volume of daily trades are highly liquid and exhibit narrow bid-ask spreads.

Market makers who facilitate trades profit from the difference between bid and ask prices.

A market maker’s focus is on market neutrality rather than directional bets. Thus, they hedge their positions by buying or selling the underlying shares.

Consequently, the liquidity of the options tied to those shares is also influenced by the liquidity of the shares themselves.

So, in an ideal scenario, it is preferable to sell options that exhibit high open interest and trading volume. In the United States, many stocks have thousands of active contracts available at any given time. However, when looking at UK options on FTSE 100 stocks, it is not uncommon to find many stocks with open interest in the single digits or even zero.

By the way, if you’d like a free PDF version of everything to do with selling covered calls and puts, you can grab a copy of my Options Selling Roadmap here.

What Are The Option Greeks In An Options Chain?

In an options chain, the Greeks are a set of metrics that help us check the risk and profitability of an options contract. Below is a brief overview of what each one means.

Delta: This measures how much an option’s price will change in relation to a change in the underlying asset’s price. Delta is the most important metric that I look at in an options chain.

Gamma: This measures how much an option’s delta will change in relation to a change in the share price.

Theta: This measures how much an option’s price will change due to the passage of time, or the option’s time decay.

Vega: This measures how much an option’s price will change due to changes in implied volatility.

Rho: This measures how much an option’s price will change due to changes in interest rates.

By looking at these metrics we can gain a better understanding of how an option will behave under different market conditions. This helps us make more informed trading decisions and become better option traders.

In summary, an options chain is a crucial tool for investors and option traders who want to buy or sell options. Just don’t be alarmed once you first see it like I was. You soon get to grips with it and after a few trades you will quickly know your way around it like the back of your hand.

FAQs:

What is the difference between a call option and a put option?

A call option is an option contract that gives the buyer the right, but not the obligation, to buy the underlying security at the strike price before the expiration date. A put option is an option contract that gives the buyer the right, but not the obligation, to sell the underlying security at the strike price before the expiration date.

How do you use Implied Volatility to see if an option is cheap or expensive?

The price, or premium, of an option is determined by combining its extrinsic value and intrinsic value.
The extrinsic value is influenced by three key factors:

1. Time to expiration.
2. Proximity to market price.
3. Volatility.

When you look at an option chain, the quoted premium reflects this price, which is seen in the bid and ask prices.
It’s important to note that you don’t need to perform these calculations yourself to determine the price of an option.

The market itself determines the price, similar to how the price of a share is determined by market participants. However, understanding whether the offered price is high or low can be valuable.

One method to assess the price is by using Implied Volatility (IV). This utilises an option pricing model, such as Black Scholes, to estimate the expected volatility of the underlying stock based on the option’s price.

By comparing the IV of different options or comparing it to historical data, you can identify options that are relatively expensive (highest IV) or cheap (lowest IV). In theory, if you spot an expensive option among the available choices, it could be considered the best one to sell.

Should You Avoid Options With Low Open Interest And Volume?

The answer to this question relies on the particular trading approach you intend to follow. If your strategy involves frequent buying and selling of options, liquidity becomes crucial.
If you would rather sell options and let them expire without the need to buy them back then the level of liquidity is less significance.

Should You Avoid Options With Low Open Interest And Volume?

The answer to this question relies on the particular trading approach you intend to follow. If your strategy involves frequent buying and selling of options, liquidity becomes crucial.

If you would rather sell options and let them expire without the need to buy them back then the level of liquidity is less significance.

Allow me to elaborate:
f you choose to exit a position before the expiration date to secure a quick profit or manage a potential loss; you would need to repurchase the option to cancel the contract.

This strategy, which can be effective with some experience, relies on having sufficient liquidity to execute it.

When you reach the point of deciding to exit an options trade, your primary objective is usually to exit swiftly, which means accepting the available price.

In a low liquidity environment, the price offered is likely to be less favourable due to limited market activity.

So if you decide to become a lot more active in your cash secured put and covered call trading then you may well be looking to buy back an option before it reaches expiration. In that case, you do need to care about liquidity.

If you find yourself in a situation where you need or choose to buy back an option. The most crucial part is to ensure there is a narrow bid-ask spread and a substantial number of traders willing to take the opposite side of your trade.

Otherwise, you may face unfavourable conditions when submitting the order.

It is advisable to sell options that possess adequate open interest and trading volume, as well as tight pricing spreads. You may discover that US options are more suitable for this type of trading due to these favourable characteristics versus the UK.

How do I trade options?

Trading options involves buying or selling options contracts.

I leave the buying to the speculators and only focus on selling options. To trade options, you need to have a brokerage account that allows you do trade in this way.

It is important to understand the risks involved in options trading. I always recommend to people to try paper trading first. You can paper trade through Interactive Brokers or Saxo Bank.



Read Also: The 3 Best Options Trading Platforms in the UK: Unveiling Top Choices for Traders

Kevin S

Kevin S

Greetings, I'm Kevin! I am now a full time options trader and investor. I am thrilled to have the opportunity to share my knowledge and expertise with you. My objective is to assist you in navigating the complexities of option trading, regardless of whether you're a beginner or an experienced trader looking to enhance your skills. I'm excited to accompany you on your journey to mastering the art of option trading. Let's make this year an extraordinary one for you!
Kevin S

Kevin S

Greetings, I'm Kevin! I am now a full time options trader and investor. I am thrilled to have the opportunity to share my knowledge and expertise with you. My objective is to assist you in navigating the complexities of option trading, regardless of whether you're a beginner or an experienced trader looking to enhance your skills. I'm excited to accompany you on your journey to mastering the art of option trading. Let's make this year an extraordinary one for you!

About DividendOnFire.com

Welcome to Dividend On Fire, we are a site dedicated to options trading! We specialize in helping investors generate passive weekly or monthly income through selling cash secured puts and covered calls.

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