Options canbe used to implement a wide array of trading strategies, ranging from simple buy and sells to complex spreads with names like butterflies and condors. In addition, options areavailable on a vast range of stocks, currencies, commodities, exchange-traded funds, and futures contracts.
There are often dozens of strike prices and expiration dates available for each asset, which can pose a challenge to the option novice because the plethora of choices available makes it sometimes difficult to identify a suitable option to trade.
- Options trading may be complicated, particularly since numerous options might exist on the same underlying, each with a distinct strike price and expiry date.
- Finding the best alternative to meet your trading strategy is consequently critical for market success.
- Beginning with an investing aim and ending with a transaction, there are six fundamental phases to evaluating and identifying the best alternative.
- Specify your goal, assess the risk/reward, consider volatility, create a strategy, and define option parameters.
Finding the Right Option
We start with the assumption that you have already identified a financial asset—such as a stock, commodity, or ETF—that you wish to trade using options. You may have pickedthis underlying using a stock screener, by employing your ownanalysis, or by usingthird-party research. Regardless of the method of selection, once you have identified the underlying asset to trade, there are the six steps for finding the right option:
- Determine your investing goal.
- Calculate your risk-reward payoff.
- Check thevolatility.
- Identify events.
- Devise a strategy.
- Establish option parameters.
The six steps followa logical thought process that makes it easier to pick a specific option for trading. Let’s breakdown what each of these steps involves.
1. Option Objective
The starting point when making any investment is your investment objective, and options trading is no different. What objective do you want to achieve with your option trade? Is it to speculate on a bullish or bearish view of the underlying asset? Or is it to hedge potential downside risk on a stock in which you have a significant position?
Are you putting on the trade to earnincome from selling option premium? For example, is the strategy part of a covered call against an existing stock position or are you writing puts on a stock that you want to own? Using options to generate income is a vastly different approach compared to buying options to speculate or to hedge.
Your first stage should be to define the trade’s goal, since this will serve as the basis for the remaining processes.
The next stage is to calculate your risk-reward payout, which should be based on your risk tolerance or risk appetite. If you are a cautious investor or trader, aggressive techniques such as writing puts or purchasing a big number of deep out of the money (OTM) options may not be appropriate for you. Every option strategy has a well-defined risk and return profile, which you should properly grasp.
3.Check the Volatility
Implied volatility is one of the most significant predictors of option pricing, so obtain a solid sense of the implied volatility level for the options you’re considering. Compare the implied volatility to the stock’s historical volatility and the volatility in the broader market, as this will be a major component in determining your option trade/strategy.
Implied volatility indicates whether or not other traders anticipate the stock to move significantly. High implied volatility raises premiums, making writing an option more appealing, providing the trader believes volatility will not continue to rise (which could increase the chance of the option being exercised).Low implied volatility indicates lower option premiums, which is advantageous when purchasing options if the underlying stock is expected to move enough to boost the value of the options.
4. Identify Events
Market-wide and stock-specific events may be divided into two types. Market-wide events, such as Federal Reserve statements and economic data releases, have a widespread influence on the markets. Earnings reports, product launches, and spinoffs are examples of stock-specific events.
An event may have a substantial influence on implied volatility before it happens, and it can have a tremendous impact on the stock price after it does. So, do you want to take advantage of the spike in volatility before a significant event, or do you want to sit on the sidelines until things calm down?
Identifying events that may have an influence on the underlying asset will assist you in determining the best time frame and expiry date for your option trading.
5. Devise a Strategy
Based on the preceding phases’ research, you now know your investment aim, desired risk-reward payout, implied and historical volatility levels, and critical events that may impact the underlying asset. Going through the four processes makes determining a particular option strategy much simpler.
Assume you are a cautious investor with a substantial stock portfolio who wants to make premium income before firms announce their quarterly results in a few months. As a result, you may pursue a covered call writing strategy, which entails writing calls on part or all of the stocks in your portfolio.
As another example, if you are an aggressive investor who enjoys long shots and believes that the markets will see a significant downturn during the next six months, you may elect to purchase put options on key stock indexes.
6. Establish Parameters
Now that you’ve determined whatever option strategy you want to use, all that remains is to set option parameters such as expiry dates, strike prices, and option deltas. For example, if you wish to purchase a call with the longest expiry date but the lowest cost, an out-of-the-money call may be appropriate. In contrast, if you want a call with a large delta, you can pick an in-the-money option.
ITM vs. OTM
An in-the-money (ITM) call option has a strike price that is lower than the underlying asset’s price, while an out-of-the-money (OTM) call option has a strike price that is higher than the underlying asset’s price.
Examples Using these Steps
Here are two hypothetical scenarios in which the six processes are employed by various sorts of traders.
Assume a cautious investor owns 1,000 shares of McDonald’s (MCD) and is worried about the stock falling by 5% or more in the next months. The investor does not want to sell the shares but does want to be protected against a potential decline:
- Objective: Protect against downside risk in present McDonald’s position (1,000 shares); the stock (MCD) is now trading at $161.48.
- Risk/Reward: The investor is OK with a little risk as long as it is quantified, but he is wary of taking on infinite risk.
- Volatility: The implied volatility on ITM put options with a $165 strike price is 17.38% for one-month puts and 16.4% for three-month strikes. The Cboe Volatility Index (VIX) measures market volatility at 13.08%.
- Events: The investor wants a hedging that goes beyond McDonald’s earnings report. Earnings are due in slightly over two months, thus options should be available for around three months.
- Strategy: Purchase puts to protect against a decrease in the underlying stock.
- Option parameters: Three-month $165 put options are offered for $7.15.
Because the investor want to hedge the stock position beyond earnings, they purchase the three-month $165 put options. The entire cost of hedging 1,000 shares of MCD with a put position is $7,150 ($7.15 x 100 shares per contract x 10 contracts). This price does not include commissions.
If the stock falls, the investor is protected since the gain on the put option will likely balance the stock loss. If the stock remains flat and trades unaltered at $161.48 just before the options expire, the puts have an intrinsic value of $3.52 ($165 – $161.48), implying that the investor might reclaim about $3,520 of the money invested in the puts by selling the puts to terminate the position.
If the stock price rises over $165, the investor profited from the increase in the value of the 1,000 shares but lost the $7,150 paid for the options.
Assume an aggressive trader is positive on Bank of America (BAC) prospects and has $1,000 to deploy an options trading strategy:
- Purchase speculative calls on Bank of America. The stock is now trading at $30.55.
- Risk/Reward: The investor does not mind losing the entire investment of $1,000, but wants to get as many options as possible to maximize potential profit.
- Volatility: Implied volatility on OTM call options (strike price of $32) is 16.9% for one-month calls and 20.04% for four-month calls. Market volatility as measured by the CBOE Volatility Index (VIX) is 13.08%.
- Events: None, the company just had earnings so it will be a few months before the next earnings announcement. The investor is not concerned with earnings right now, but believes the stock marketwill rise over the next few months and believes this stock will do especially well.
- Strategy: Buy OTM calls to speculate on a surge in the stock price.
- Option Parameters: Four-month $32calls on BAC are available at $0.84, and four-month $33calls are offered at $0.52.
Because the investor wants to buy as many inexpensive calls as possible, he chooses the four-month $33calls. Excluding commissions, 19 contracts at $0.52 each are purchased for a total cash expenditure of $988 (19x $0.52 x 100 = $988), plus fees.
The theoretical maximum benefit is limitless. If a worldwide banking giant comes along and agrees to buy Bank of America for $40 in the next several months, the $33 calls are worth at least $7 apiece, and the option position is worth $13,300. The trade’s breakeven point is $33 + $0.52, or $33.52.
If the stock is valued at more than $33.01 at expiry, it is in-the-money and will be subject to auto-exercise. The calls, however, may be closed at any moment before to expiry through a sell-to-close transaction.
It is worth noting that the strike price of $33 is 8% higher than the current price of the stock. The investor must believe that the price will rise by at least 8% during the following four months. If the price does not rise over the strike price of $33 before expiration, the investor would lose the $988.
The Bottom Line
While the large choice of strike prices and expiry dates may make it difficult for a new investor to hone in on a certain option, the six stages indicated below follow a logical thinking process that may aid in option trading selection. Specify your goal, analyze the risk/reward, consider volatility, events, plan your strategy, and define your option parameters.
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