Choose the right trading option in six steps

Options can be used to implement a wide range of trading strategies, from simple buying and selling to complex spreads such as butterflies and condors. In addition, options apply to a wide range of stocks, currencies, commodities, exchange-traded funds and futures contracts.

There are usually dozens of available strike prices and expiration dates for each asset, which may pose a challenge to novice option players, because the large number of options available makes it sometimes difficult to determine the appropriate trading option.

Key points

  • Options trading can be complicated, especially because there may be many different options for the same underlying, and there are a variety of strike prices and expiration dates to choose from.
  • Therefore, finding the right option that suits your trading strategy is critical to achieving maximum success in the market.
  • There are six basic steps to evaluate and determine the right choice, starting with investment goals and finally trading.
  • Define your goals, assess risk/return, consider volatility, predict events, plan strategies and define option parameters.

Find the right choice

We first assume that you have identified the financial assets (such as stocks, commodities, or ETFs) that you want to trade with options. You may have selected this underlying security using a stock screener, your own analysis, or third-party research. No matter which method you choose, once you have determined the underlying asset you want to trade, you can find the right choice in six steps:

  1. Develop your investment goals.
  2. Determine your risk-reward return.
  3. Check for volatility.
  4. Identify the event.
  5. Develop strategies.
  6. Establish option parameters.

These six steps follow a logical thinking process, making it easier to choose specific trading options. Let us break down the content involved in each step.

1. Option objective

The starting point for any investment is your investment goal, and option trading is no exception. What do you hope to achieve through option trading? Is it speculating on the bullish or bearish view of the underlying asset? Or is it to hedge against potential downside risks in stocks in which you hold important positions?

Are you trading to earn income by selling option premiums? For example, is the strategy part of a guaranteed call option on an existing stock position, or are you writing a put option for the stock you want to own? Compared with buying options for speculation or hedging, using options to generate income is a completely different method.

Your first step is to set the goal of the transaction, because it forms the basis for the next steps.

2. Risk/Reward

The next step is to determine your risk-reward return, which should depend on your risk tolerance or risk appetite. If you are a conservative investor or trader, then aggressive strategies such as selling put options or buying a large number of deep out-of-the-money (OTM) options may not be suitable for you. Every option strategy has clearly defined risk and reward characteristics, so make sure you understand it thoroughly.

3. Check the volatility

Implied volatility is one of the most important determinants of option prices, so please read carefully the implied volatility level of the option you are considering. Compare the implied volatility level with the stock’s historical volatility and the market volatility level, as this will be a key factor in determining your options trading/strategy.

Implied volatility lets you know if other traders expect the stock to fluctuate significantly. High implied volatility will push up premiums and make options more attractive, assuming that traders believe that volatility will not continue to increase (this may increase the chance of options being exercised). Low implied volatility means cheaper option premiums. If the trader expects that the underlying stock will be sufficient to increase the value of the option, this is conducive to buying options.

4. Identify the incident

Events can be divided into two broad categories: market scope and specific stocks. Market-wide events are those that affect a wide range of markets, such as Fed announcements and economic data releases. Stock-specific events are things such as earnings reports, product launches, and spin-offs.

The event may have a significant impact on the implied volatility before it actually occurs, and the event may have a huge impact on the stock price when it occurs. So, do you want to take advantage of the surge in volatility before critical events happen, or would you rather wait and see until things stabilize?

Identifying events that may affect the underlying asset can help you determine the appropriate time frame and expiration date for option transactions.

5. Develop a strategy

Based on the analysis performed in the previous steps, you now know your investment objectives, expected risk-return returns, implied and historical volatility levels, and key events that may affect related assets. Completing these four steps can make it easier to determine a specific option strategy.

For example, suppose you are a conservative investor with a large stock portfolio and want to earn a premium income before the company starts reporting its quarterly earnings in a few months. Therefore, you can choose a guaranteed call option strategy, including call options on some or all of the stocks in your portfolio.

To give another example, if you are an aggressive investor who likes long-term investments and are confident that the market will fall sharply within six months, you might decide to buy put options on major stock indexes.

6. Establish parameters

Now that you have determined the specific option strategy to implement, all that remains is to establish option parameters such as expiration date, strike price, and option increment. For example, you may want to buy the call option with the longest expiration time at the lowest possible cost. In this case, an out-of-the-money call option may be appropriate. Conversely, if you want high-increment call options, you may prefer in-the-money options.

ITM and OTM

The strike price of an in-the-money (ITM) call option is lower than the price of the underlying asset, and the strike price of an out-of-the-money (OTM) call option is higher than the price of the underlying asset.

Examples of using these steps

Below are two hypothetical examples where six steps are used by different types of traders.

Suppose a conservative investor owns 1,000 shares of McDonald’s (MCD) stock and is concerned about the possibility that the stock will fall by more than 5% in the next few months. Investors do not want to sell stocks, but do want to prevent a possible decline:

  • Goal: to hedge the downside risk currently held by McDonald’s (1,000 shares); the stock (MCD) is trading at US$161.48.
  • Risk/reward: As long as it is quantifiable, investors don’t mind a little risk, but they are not willing to take unlimited risks.
  • Volatility: The implied volatility of ITM put options (strike price of $165) is 17.38% for 1-month puts and 16.4% for 3-month puts. The market volatility measured by the CBOE Volatility Index (VIX) was 13.08%.
  • Event: Investors want to hedge beyond McDonald’s earnings reports. The earnings came out after more than two months, which means that the option should be extended for about three months.
  • Strategy: Buy put options to hedge against the risk of falling underlying stocks.
  • Option parameters: The price of a put option with a three-month strike price of US$165 is US$7.15.

Because investors wanted to hedge stock positions that exceeded their earnings, they purchased a three-month put option of $165. The total cost of hedging a put position of 1,000 shares of MCD is US$7,150 (US$7.15 per contract x 100 shares x 10 contracts). This fee does not include commissions.

If the stock falls, investors will be hedged because the gains from the put options may offset the losses of the stock. If the stock is flat and trades at US$161.48 shortly before the expiration of the put option, the intrinsic value of the put option will be US$3.52 (US$165-US$161.48), which means that investors can recover their investment in put options in the following ways About $3,520 of the amount was sold put options to close the position.

If the stock price rises above US$165, the investor will profit from the increase in the value of 1,000 shares, but will lose the US$7,150 paid for the option

Now, suppose an aggressive trader is optimistic about the prospects of Bank of America (BAC) and has $1,000 to implement an option trading strategy:

  • Goal: Buy speculative calls from Bank of America. The stock is trading at $30.55.
  • Risk/Return: Investors don’t mind losing the entire investment of $1,000, but want to get as many options as possible to maximize potential profits.
  • Volatility: The implied volatility of OTM call options (strike price of $32) is 16.9% for 1-month call options and 20.04% for 4-month call options. The market volatility measured by the CBOE Volatility Index (VIX) was 13.08%.
  • Event: None, the company has just received earnings, so there are still a few months before the next earnings announcement. Investors do not currently care about earnings, but believe that the stock market will rise in the next few months, and believe that this stock will perform particularly well.
  • Strategy: Buy OTM phones to speculate on the surge in stock prices.
  • Option parameters: The price of a call option of $32 for the last 4 months of BAC was $0.84, and the price of a call option of $33 for four months was $0.52.

Since investors wanted to buy as many cheap phones as possible, they chose a phone that cost $33 for 4 months. Excluding commissions, for the purchase of 19 contracts or US$0.52 each, the cash outlay is US$988 (19 x 0.52 x 100 = US$988), plus the commission.

Theoretically, the maximum gain is unlimited. If a global banking group proposes to acquire Bank of America for $40 in the next few months, each $33 call option is worth at least $7 and the option position is worth $13,300. The breakeven point of the transaction is 33 USD + 0.52 USD, or 33.52 USD.

If the stock is higher than $33.01 at maturity, it is in the money, has value, and is automatically exercised. However, the call option can be closed through a sell-to-close transaction at any time before expiration.

Note that the strike price of $33 is 8% higher than the current price of the stock. Investors must be sure that prices can rise by at least 8% in the next four months. If the price is not higher than the execution price of $33 at maturity, the investor will lose $988.

Bottom line

Although a wide range of strike prices and expiration dates may make it difficult for inexperienced investors to zero out a particular option, the six steps outlined here follow a logical thinking process and may be helpful in choosing options to trade. Define your goals, assess risk/return, view volatility, consider events, plan your strategy and define your option parameters.

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