As an options trader, determining the right underlying stock to trade is extremely important. This is sometimes overlooked however it can be the difference between being a successful options trader and a struggling one. To increase their chances of trading options successfully, traders must not only focus on what options to trade but should also dedicate more time and effort in selecting the right underlying stocks to trade.
An options trader not only has to be correct re the price movement of a stock, but he/she must also be right in predicting when the price movement will occur. So, being able to identify the right stocks and forecast stock price movements within a specific time frame is crucial. As such some amount of research and analysis is necessary if options traders want to consistently find the right stocks to pair with their options trading strategy.
So, how can options traders choose the right stocks for Options Trading?
Finding The Right Stocks
In trying to find the right underlying stocks, options traders should among other things:
- Do some research
- Choose liquid stocks to invest in
- Look for medium to higher priced stocks
- Consider trading reasonably volatile stocks
- Look at historical data and charts to identify trends
- Identify upcoming events that might impact stock prices
- Monitor Stocks actively discussed in forums, message boards etc.
- Utilize a good stock screener
Do Some Research
In order to be a successful investor or trader, you need to commit to some research to find the best stocks to trade or invest in. Do some market or industry-related research, review historical stock data, review earnings reports, monitor upcoming events and consider how these events could impact stock prices, look at the management teams of companies that you want to invest in, monitor their websites and press releases, look at the products or services these companies provide, the countries they operate in, look for stocks with a proven record of success etc. My point is, don’t invest blindly, as investments made with little or no research can result in significant losses.
Choose Liquid Stocks
In selecting the stocks to utilize for your options trading strategy, it is essential that you choose from a liquid pool of stocks. Liquidity is very important when looking for stocks and options to trade as it allows you to be able to get in and out of a trade more easily. The most liquid stocks are usually those with higher volumes, so you need to focus on finding and trading high volume stocks. Pay attention to the average volume over time as a high average volume indicates that the trading volume of a stock is ongoing and not due to an upcoming event. Thinly traded stocks tend to be unpredictable and are extremely speculative, so try to avoid these if possible. To help with their decision, option traders can utilize historical data, charts and stock screeners to identify average volume trends.
Look at Historical Data and Charts to Identify Trends
As previously mentioned, traders should utilize charts and other historical data where possible to help them find the right underlying stocks to trade. Although past performance is not indicative of future results, looking at a company’s historical stock performance is still very useful and is highly recommended if you have the tools or resources to do so. Investors can review historical prices to find support and resistance levels, or for helping them to determine a company’s valuation and growth potential.
Choose Medium to Higher Priced Stocks With a wide Daily Range
Medium or higher priced stocks usually offers a good range of movement which can have a greater impact on your options trading strategy. Look to trade reasonably volatile stocks that offer a wide daily range for you to profit more easily. This is very important because if your stocks do not move sufficiently, you will have a harder time getting in and out of a trade, covering your commissions and earning a decent profit. Try to find stocks that are a bit volatile with a higher average daily range, more than just $1 or a few dollars. To find stocks with a wider daily range, review the high-low ranges of the market leaders or of the stocks you’re interested in trading. Ensure that the range is wide enough and that the range happens regularly, especially if you plan to keep trading the stock.
Monitor Implied Volatility
Volatile options trading strategies are very popular for their ability to return a profit regardless of whether the underlying stock goes up or down, as long as the move is significant. Implied volatility is one of the most important factors in determining an options price so it’s essential to pay very close attention to a stock’s volatility when trading options. Implied volatility is basically telling you whether the market is expecting a stock to move a lot or not. With higher volatility comes higher premiums which makes writing a call more attractive assuming the volatility will not continue to increase to the point of causing the option to be exercised. On the other hand, lower implied volatility means cheaper priced options which benefits the options buyer if a trader believes that the underlying stock will move enough to finish further in the money. Traders should also compare a stock’s historical volatility with its implied volatility to get a broader picture of what to expect. It’s important that as an Options trader you keep a keen look out for any major events that could affect the implied volatility of an underlying stock which can significantly affect the stock price.
Identify Upcoming Events that Might Impact Stock Prices
Options traders should pay very close attention to 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 stock prices. Your aim should be to predict when a stock is likely to have a big price movement, get in before that movement and exit before the movement is over and starts to reverse.
Such events before their occurrence, can have a huge effect on implied volatility, which can significantly impact a stock price when they eventually occur. Identifying upcoming events that may impact an underlying asset or stock price will help options traders decide on the right expiration or time frame for their option trade.
If traders want to capitalize on any surge in volatility before an event, they need to be prepared and must be keenly aware of any upcoming events that could potentially affect a position. Hence monitoring a company’s official web site where you might find lots of useful information, including press releases, planned events and company news is recommended. Also monitor stocks actively discussed in forums and message boards.
Determine Your Investment/Trading Objective
Options traders must determine what their investment or trading objectives are. By doing so traders can clearly define what their goals are which helps them choose investment strategies that are in alignment with those objectives. Are you conservative or are you trying to speculate on a bullish or bearish trend?
If you are conservative, focus on choosing solid, safer stocks for your trading strategy. Buy stocks based on sound fundamentals and not just for the purpose of trading options.
Utilize Stock Screeners
Stock screeners are also useful tools that investors and traders can use to filter stocks based on some pre-defined metrics, which allow users to accurately and quickly select stocks that fit a particular profile. For example, users can screen for stocks based on their price, price range, price triggers, volatility, market cap, average volume, p/e ratio, dividend yield and much more. Investors can use screeners to analyze historical data, past earnings results, technical indicators and more to find stocks that are poised to do well in the future.
Do you see how useful such a screening tool would be in finding the right stocks for your options trading strategy and also saving tonnes of time? With a good stock screener, investors or traders could analyze hundreds of stocks in a short period of time, allowing them to eliminate those stocks that don’t meet the necessary requirements.
The steps outlined above should help options traders select more suitable underlying stocks to compliment their options trading strategy. Before venturing into options trading, traders should among other things: do their diligent research, trade more liquid stocks, review historical data and charts to identify trends, identify events that might impact stock prices, and utilize stock screeners to minimize the guess work and save time.