Options can be traded alone or in various combinations, with so many strategies at your finger tips, it can sometimes be a daunting task to pick the best strategy for your needs. To increase your chances of options trading success, you must not only select the right underlying stocks, but also choose the right options strategy to trade. Some options traders have no problem picking the right direction or price movement of a stock, however a lot of them still end up missing out on potential gains or more profitability, because they failed to use the right option. As such, options traders should devote more focus and attention to learning how to select the right options to maximize potential profits and minimize losses.
Picking the right options
Let’s say that based on your research you are now very confident in the direction of a stock price and have identified the stocks that you wish to trade. You’re ready and its now time to find the right options to utilize, but you don’t know where to start. How do options traders decide which option to use to achieve their trading goals or match their trading expectations?
- Should they use at-the-money, in-the-money or out-of-the-money options?
- Should they be more conservative or aggressive?
This article will provide options traders with a few simple steps to help them decide on or choose options that are more suitable for their individual trading needs based on what they are trying to accomplish.
Determine your investment/trading objective
As an options trader, one of the first things that you need to do is to determine what your investment or trading objective is. Your investment objective is your overall outlook or plan for your trading or investment account. It clearly defines what your goals are, which helps you choose trades or investment activities that are aligned with or suitable for the objectives that you want to accomplish. Before choosing what options to utilize, ask yourself this simple question: What exactly are you looking to achieve from options trading?
- Are you trying to speculate, on a bullish or bearish trend?
- Are you looking to hedge against a possible downside risk of your stock holdings?
- Are you looking to earn premium income or some extra income from your trading?
Once you have your answers and you have clearly defined your investment objectives, then you need to select options that align to those objectives.
Determine your Risk tolerance
As an options trader, you need to know your risk tolerance or appetite for risk.
- What level of risk of are you willing or able to tolerate to help you achieve your investment goals?
- What’s your level of trading expertise and are you conservative or aggressive?
If you consider yourself a conservative trader, then it would not make sense for you to utilize aggressive trading strategies such as buying lots of out of the money options or writing naked calls. Each option strategy has its very own risk reward profile, so make sure you take the time to fully understand each strategy that you choose to utilize.
In-the-money or at-the-money options have less risk of expiring worthless than their out-of-the-money counterparts and are much more attractive to conservative traders. However, if you are a more aggressive trader, who enjoys going after big profits or big wins, you might be more inclined to utilizing out-of-the-money contracts.
If you’re an options trader trying to determine your risk reward profile, here is a simple tip, do whatever makes you feel the most comfortable. If it doesn’t feel right, then don’t do it. If you’re going to lose plenty of sleep over a trading strategy or options type, then it might not be a good idea to move forward.
Try to monitor or gauge volatility
Options traders should try to gauge or have a good idea of the level of implied volatility for options that they are considering, as this is one of the most significant determinants of an option’s price. Look at a stock’s historical volatility and the level of volatility in the broader market, as these will be highly important in helping you identify your options trading strategy.
Higher implied volatility will drive premiums up, which makes writing an option more attractive to options traders. If Implied Volatility is high, traders know that they have the opportunity to sell premium. However lower implied volatility drives down premiums resulting in cheaper option premiums, which is good for buying options especially if an options trader expects the underlying stock to move enough to put the option further in the money. If implied volatility is low, options traders tend to lean towards options strategies such as long calls/puts and long vertical spreads.
Identify upcoming events that might have an impact
Options traders should pay very close attention to market-wide or stock-specific events. Events such as economic data releases, federal reserve announcements, election results, economic data releases, earnings reports, and product launches can have a significant impact on the markets.
Such events can have a huge effect on implied volatility before their occurrence, which can significantly impact a stock price when they eventually occur. Identifying upcoming events that may impact an underlying asset or stock price can help options traders decide on the right expiration or time frame for their options trade.
If options traders want to capitalize on any surge in volatility before an event, they need to be prepared. You want to make sure that you’re aware of any upcoming events that could potentially affect your position, so monitoring a company’s official web site is not a bad idea as you might be able to find lots of useful information, including press releases, planned events, company news, etc.
With the wide range of options, trading strategies, strike prices and expirations available, this may make it very challenging and overwhelming for inexperienced traders to select the right options. However, the steps outlined here in this article should help options traders in their efforts to select more suitable options to trade. Options traders should clearly define what their investment objectives are, determine their risk tolerance, analyze volatility, monitor upcoming events, and select the right trading strategies, in trying to fund the right options to increase their chances of trading success.