Robinhood has made it easy for new investors and traders to get into trading, especially options. However, it can be a double-edged sword that can also blow up your account if you don’t understand option greeks.
In this simple and detailed guide, I will be going over how I was able to get my MARA stock cost basis to zero selling covered calls and continue to earn income from it by holding onto the stock. Gaining assets that can make you income yearly is very valuable, especially when you have taken risk off the table.
Before we get into the nitty gritty details, please understand that if you do not have risk management in place, it is extremely easy to lose money.
Robinhood Options Level
Robinhood has made it easy to apply for options level 2 trading. You will need to answer a few questions for them to approve you. If you don’t get approved, then most likely you are not quite ready for options just yet.
At options level 2, you will unlock the following:
- Buy/sell a Call or Put
- Sell Covered Calls and Cash-Secured Puts
- Straddles and Strangles (Not covering on this guide)
- Credit and Debit Spreads
These 4 types will be more than enough to keep you busy and allow you to pick a strategy that suits you the best.
All options are affected by the option greeks, which determines how options are priced. Depending on the strategy you use, some greeks are more important to pay attention to then others. There are 5 greeks that you will want to know about when trading options:
- Delta – Delta measures how much an option’s price can be expected to move for every $1 change in the price of the underlying security or index.
- Theta – Theta tells you how much the price of an option should decrease each day as the option nears expiration, if price remain the same. This kind of price erosion over time is known as time decay.
- Gamma – Gamma measures the rate of change in an option’s Delta over time.
- Vega – Vega measures the rate of change in an option’s price per one-percentage-point change in the implied volatility of the underlying stock.
- Rho – Rho measures the expected change in an option’s price per one-percentage-point change in interest rates. It tells you how much the price of an option should rise or fall if the risk-free interest rate (U.S. Treasury-bills)* increases or decreases.
You can check the options greeks on Robinhood by clicking on “Trade Options” and hover over either a call or put option. Click on it and you will be able to see the options greeks below.
For example, MARA is trading at $24 on March 17th 2022. The $23.50 call option that expires March 18th 2022 is priced at $1.25. Keep in mind that options are always priced with 100 shares per contract. So a $1.25 contract means $125 for 100 shares.
At the bottom of the picture, you will see the following:
Delta – 0.6527
What this means is that for every $1 move up or down, the price of the contract moves roughly $0.65. If the price increases, the delta will increase. If the price drops, so will delta.
Gamma – 0.1738
This measures the change of delta over time. It may increase/decrease $0.17 over a period of time. Since the $23.50 call is near the money, it is very sensitive to gamma change. When an option moves away to deep out the money or deep in the money, the gamma change is also less.
Theta – 0.2765
This measures the rate of decay of the contract. So if you buy a Call/Put option, the price decays about $0.27 per day, assuming that price stays the same. As a buyer of the Call/Put option, you are subject to time decay and you want price to move quickly, or you will end up losing money despite price moving in your favour.
For option sellers, this will work in your favour as the option price decays and you earn the time decay from it.
Vega – 0.0056
This means that the price of the option changes $0.0056 per 1% increase/decrease in volatility of the stock. For example, let’s say the current volatility is 100% . If it increases to 110%, then:
- 10 x 0.0056 = 0.056
So if the option price is $1.25 prior to the volatility change, then the new option price would be ~$1.31 (rounded up). Now if it decreases to 80%, then:
- 20 x 0.0056 = 0.112
So the new option price of $1.25 will become ~$1.16(rounded up) when volatility decreases.
Rho – 0.0006
This is usually negligible when trading options, unless you are buying/selling 1-2 year leap options.
Of these 5 greeks, Delta, Gamma and Theta are the ones you want to pay attention to the most. Since these 3 affects how your option price changes on a short term basis. Since the options contract expires the next day on March 18th 2022, The $23.50 call option will expire in the money as long as MARA trades above $23.50 on options expiration day on Friday.
We will go over at, in and out the money options next.
Buying Put and Call Options – In, At and Out the Money
When you buy a call option, it will be categorized as in the money when the call strike price is below the current trading price. It is at the money when the stock price is trading exactly at the strike price of the call. It is out the money if the stock price is currently trading below the strike price.
When you buy a put option, the opposite happens.
It will be categorized as in the money when the put strike price is above the current stock price. It is at the money when the stock price is trading exactly at the strike price of the put. It is out the money if the stock price is trading below the strike price.
The good thing about buying calls and puts is that you only stand to lose the total value of the options contract you bought. Now, I will use a few examples to put all of these together.
Buying a Call (Bullish)
If you think the stock price is going up, buying a call will reflect that.
Currently, MARA has a closing price of $23.85. We are looking at the 14th April 2022 calls. These expire roughly in 29 days. If you were to buy a call, being out the money or in the money will make a difference in how your profit or loss will look.
If you think that price will go up in 30 days and bought an out the money call at a strike price of $30, it would cost only $1.24 per contract. While it is cheaper, the call option is also subject to higher theta decay due to it being out the money.
In the money call option will cost more, but the theta decay will be less severe. For example, if you were to buy the $20 strike call option that costs $5.63 per contract, the profit/loss chart would look way different.
Generally, in the money call options have a much higher chance to profit compared to out the money call options. Out the money call options, however, do great when stock price moves quickly. If MARA were to rally from $24 to $30 within a week, then the $30 call option would gain value quickly while not losing too much in theta decay. It is more of a high risk, high reward play. When buying calls and puts, the most you could lose is the amount you put in.
Buying a Put (Bearish)
When you are bearish on a stock or index, you will be looking to buy puts. Investors and traders also buy puts to hedge their positions. Much like calls, puts are also subject to theta decay. They are not meant to be held for too long, even if it is a year out put.
For example, if you were bearish on MARA, which is currently trading at $27.95:
Let’s say you believe that MARA will drop below $25 in 25 days where the contract expires on April 14th of 2022. You would pay a premium of $1.80 to the option seller. Since the put is out of the money, it is significantly cheaper than a in the money put option. Again, theta decay is faster when it is out the money.
Again, time is your enemy here and you need price to move quickly in your favour. Puts are a great way to benefit when a stock or index goes down, especially in a bear market or deep corrections, as the moves are fast.
If the deep in the money $35 put was bought, then the theta decay is less, but you will also be risking more money on the table. So that is the trade off.
So it all depends on how much risk you want to take. Deep in the money options give your plays to work out with more time. Understanding this is important and allow you to take on calculated risks before putting on a trade.
Selling Options Premium – In, At and Out the Money
Most people that venture into options are familiar with buying options, but selling options is not as popular. This is because the reward isn’t as lucrative as call/put options where you can make high percentage gains in a short period of time. For every call or put you buy, there is someone selling them to you. They are the ones that are taking the other side and for doing so, they earn some premium for taking on the risk.
There are 2 primary ways to earn options premium. You either sell a cash-secured put or own 100 shares of a stock and sell covered calls. You can also use margin to sell options premium, but that is not recommended at all, especially for a beginner.
Why Sell Options?
People sell options for many reasons. Some of the main reasons are:
- To protect their capital or hedging
- To buy a stock at the desired price they prefer
- To earn income
A cash-secured put allows you to sell a put option at a specific strike price of a stock. In exchange for that, you earn a premium. Let’s take a look at an example below on Robinhood.
For example, the $20 strike offers a premium of $0.88 per contract for options that expire on the April 14th 2022 (roughly 28 days at the time of writing). Your actual buy price of MARA would be the breakeven, which is $19.12, should the stock price close at or below $20.
If stock price closes above $20 at 14th April 2022, you get to keep the premium. This allows you to make some money off your investment even though you would like to buy it at $19.12.
When you sell a put option below the stock price, it is out the money. If you sell the put option at the stock price, it is at the money. if you sell a put option above the stock price, it is in the money.
Let’s take a look at the option greeks for the $20 strike, expiring April 14th of 2022.
The delta is sitting at -0.15. The delta moves lower to -0.01 as the stock price moves higher. When the stock price moves lower towards the $20 strike, the delta value moves higher towards -0.5 delta. For example, if your premium was at $0.88 at the time you bought it, then if the stock price drops to $20 the next week, then your premium would lose more value, causing you to have a temporary loss.
The theta sitting at -0.04 means that everyday, the price of the premium would decay 4 cents or so. Here is a graph representation of what it looks like:
Selling options premium is a higher probability trade, but it also has its risks. For example, if the stock price dumps to $10, you are stuck holding it at a loss. The only difference between buying the stock outright and selling a put option is you get a premium for waiting.
The risk of the “infinite loss” of selling put options can be mitigated by trading them on stock indexes or large blue cap stable stocks. These are less likely to depreciate in price rapidly, unlike smaller cap stocks. Alternatively, you can also buy a put below your option strike price, limiting your losses should the stock drop drastically in price in exchange for a smaller premium gain. This turns into a credit spread, which I will go over later.
For some people, they would call this picking up nickels in front of a steam roller. It makes sense, and that is why some people shy away from selling put options.
There is also another way to manage the risk of selling a put option when price goes against you. You can roll the contract for more/less premium depending on the strike price to another later date and wait for the stock price to recover.
When you own 100 shares or more of stock, you can sell a covered call. Covered calls are great at:
- Reducing downside risk in exchange for limited upside gain
- Lower your stock cost basis
- Hedging your stock
Since it limits the upside of how much capital gains you can make on a stock, most people would prefer selling puts instead. However, I personally prefer this strategy as it really protects my stock from depreciating in value too much should things go south.
I was able to reduce my MARA stock cost basis to 0 and earn more premium while owning the stock.
It is a great tool to generate income and protect your asset at the same time. I combine it with buying puts to hedge the downside sometimes during downtrends.
I will illustrate a few scenarios when it comes to selling covered calls.
MARA is currently trading at $25.95 on March 18th 2022. Let’s just say you did some technical analysis and believe that MARA will not be going over $35 by March 15th 2022. So you sell the $35 covered call and collect $0.78 in premium. As long as the stock price does not close above $35, you will keep the premium and stock.
However, if the stock price goes pass it at expiration, you will have to make a decision. You can give up the shares and sell your stock for a profit + keep the premium. The other alternative is to roll the contract to a later date and take the loss on the covered call.
When you sell a covered call above the stock price, it is an out the money covered call. It is at the money when you sell a covered call at the current stock price. If you sell a covered call below the current stock price, it is a in the money covered call.
So when it has a delta of 0.2076, it means that the option moves roughly 20 cents per dollar move of the stock price. When the stock price rises, so will the delta value. Vice versa, when the stock price decreases, so will the delta value.
The theta value is -0.0398. So that means each day, the covered call price decreases roughly 3.98 cents until expiration. Here is a quick visual of the profit/loss ratio.
If the stock trades below $35, you get to keep your premium and reduce your cost basis by $0.78 per share. You can then use the extra premium to buy more shares if you choose to. That is the beauty of covered calls.
So what happens if the stock price rockets past $35? You will have to make a choice of selling or buying the call back. Most of the time, I will just roll the contract to the next month to further collect more premium or take a loss. It is not the end of the world like what most people think it is. I have taken many losses from buying back my calls and still came out on top over a long period of time. Do keep in mind that your stock also appreciated in value, so you didn’t lose all that much.
When selling put options or covered calls, there is always a risk of assignment when the options go in the money before expiration. If you are trading American style options, the premium buyer can exercise at any time when it goes in the money. However, it is not common for people to exercise the options before expiration date, as there is still a lot of time premium left in the contract.
There are some cases where people will exercise the contract early. Some examples include selling covered calls on dividend stocks where the dividend payment date is near. If it is in the money, the option buyer may choose to exercise early to earn the dividend payment. Also, if your option contract is deep in the money where the delta is 0.95+, it might get exercised, especially if the options have poor liquidity.
I have personally not been exercised early at all in my 300+ trades of selling covered calls, when more than 30% of the trades were in the money covered calls that I sold. So if you worry about early assignment, it is not highly likely unless you are selling very deep in the money options or the stock options itself is very illiquid.
Poor Man’s Covered Call (PMCC)
For an account under $5000, it will be a lot harder to trade quality stocks, especially if you want to sell covered calls. In order to sell calls like Apple, Facebook or any stock above $100, using the PMCC is a good way to do so.
The PMCC is executed by buying a call and selling a covered call of a stock. This strategy gives small accounts a way to trade quality stocks and also be able to mitigate theta decay so that your long call option does not lose so much value over time.
Here is an example of a PMCC in action.
Let’s say you believe Apple will increase in value over the coming month.
Apple is currently trading at $164.34. The $160 call strike is currently trading at $7.03 with roughly 25 days to expiration. So assuming we are going to implement the PMCC. I buy the $160 call for $7.03. I believe that Apple will be trading below $170 by then. So I go ahead and sell the $170 call for $1.80.
The total cost of the trade would be $5.23. Below is the profit loss table to help you visualize what happens as time goes by.
As you can see, the theta decay is not as severe. If you were to only buy the the $160 call, the profit/loss table would look like this:
Without selling the upside call, you would have heavier theta decay over time, eating up profits as time goes on. However, on the flip side, if Apple rockets quickly past $170 in a week, you would also make more money. So the trade off is how risky you want it to be. Time is the enemy here.
Credit spreads are the advanced version of covered calls and cash-secured puts. It requires way less collateral and is flexible in how much you want to risk.
Bull Put Spread (Bullish)
The bull put spread is basically selling a put and buying a put at a lower strike price. If stock price moves higher, the spread will gain a profit.
For example, I am using an example of opening a bull put spread by buying a March 25th 20202 $26 put and selling a $27 put. At the time of writing, it is 5 days to expiration.
The max profit potential is $33 per contract and the max loss is $67. It has roughly a 1 to 0.5 risk to reward ratio. For every dollar you risk, you can gain the same amount and potentially lose $2. Although it doesn’t look like it is worth the risk since you are losing more when the trade goes against you, it does allow price to go against you a little and still come out on top.
The good thing about this is it can be adjusted to your preference.
If you adjust the spread slightly by going with selling the $29 put and buying the $28 put, your reward to risk ratio becomes 1 to 0.8.
However, you will need price to go in your favour, otherwise you can still lose the trade should price only moves slightly up, which is $28. If you would like to have a higher reward to risk ratio, then the strike price needs to move higher.
Should we go with selling the $30 put and buying the 28 put, then the profit loss graph would look like this:
The risk to reward ratio is 1 to 1.6. Much better in terms of ratio, but you do need price to definitely go in your favour by at least a dollar.
These are just some short term examples. It is flexible and you can also do 1 month to even 2 year spreads, but most traders will go with shorter term spreads.
Bear Call Spread (Bearish)
Bear call spreads are basically selling covered calls without having to buy the underlying shares. The shares are replaced by buying a call that is above the strike price of the covered call. If price moves downwards, the bear call spread will profit.
I will be using MARA again for this.
In this example, if I bought the $28 call and sold the $26 call expiring in about 2 weeks, I will have a profit/loss table of something like this:
In this case, the risk to reward ratio is 1 to 1.38. Price does need to move down in your favour by at least a dollar by expiration in order for you to get a profit. Here is another example:
In this case, I go with buying the 29 call and sell the 27 call. The profit/loss table looks like this:
This is almost a 1 to 1 risk to reward ratio. In this case, price can stay flat and you can still stand to gain a little profit. Keep in mind that these are just rough estimates and they are subject to options greek changes.
Assignment Risk and Dangers of Credit Spreads
One of the biggest risks Bull Put Spreads and Bear Call Spreads is when stock price stays between your spread strike prices and you do not close both positions after options expiration. If stock price moves in after hours, it can execute 1 leg of the spread and can incur big losses.
The key take away is to ALWAYS close out your spread before options expiration. That will 100% prevent this. If this is confusing, please have a look at projectfinance’s video about an incident of a trader losing $30,000 off a $1 wide credit spread:
You do not want any part of this. You have been warned!
This sums of options level 2 trading on Robinhood. With these strategies, it is more than enough for you to grow your small account. Pick a one that suits your trading style. At the end of the day, no matter which one you choose, you will still need a trading edge to profit from the markets and also practice proper risk management.
Hope this helps and happy trading on Robinhood!