Opportunities can be used to implement a wide array of trading strategies, ranging from simple buy and sells to complex spreads with cites like butterflies and condors. In addition, options are available on a vast range of stocks, currencies, commodities, exchange-traded funds, and futures obligations.
There are often dozens of strike prices and expiration dates available for each asset, which can pose a take exception to to the option novice because the plethora of choices available makes it sometimes difficult to identify a suitable option to barter.
- Options trading can be complex, especially since several different options can exist on the same underlying, with multiple lambastes and expiration dates to choose from.
- Finding the right option to fit your trading strategy is therefore essential to broaden success in the market.
- There are six basic steps to evaluate and identify the right option, beginning with an investment unbigoted and culminating with a trade.
- Define your objective, evaluate the risk/reward, consider volatility, anticipate results, plan a strategy, and define options parameters.
Finding the Right Option
We start with the assumption that you include already identified a financial asset—such as a stock, commodity, or ETF—that you wish to trade using options. You may be dressed picked this underlying using a stock screener, by employing your own analysis, or by using third-party research. Regardless of the method of piece, once you have identified the underlying asset to trade, there are the six steps for finding the right option:
- Formulate your investment goal.
- Determine your risk-reward payoff.
- Check the volatility.
- Identify events.
- Devise a strategy.
- Establish option parameters.
The six be on ones guards follow a logical thought process that makes it easier to pick a specific option for trading. Let’s breakdown what each of these heeds involves.
1. Option Objective
The starting point when making any investment is your investment objective, and options craft is no different. What objective do you want to achieve with your option trade? Is it to speculate on a bullish or bearish scrutinize 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 swap to earn income from selling option premium? For example, is the strategy part of a covered call against an existing livestock position or are you writing puts on a stock that you want to own? Using options to generate income is a vastly different advance compared to buying options to speculate or to hedge.
Your first step is to formulate what the objective of the trade is, because it kinds the foundation for the subsequent steps.
The next step is to determine your risk-reward payoff, which should be dependent on your gamble tolerance or appetite for risk. If you are a conservative investor or trader, then aggressive strategies such as writing puts or corrupting a large amount of deep out of the money (OTM) options may not be suited to you. Every option strategy has a well-defined risk and reward further, so make sure you understand it thoroughly.
3. Check the Volatility
Implied volatility is one of the most important determinants of an option’s evaluation, so get a good read on the level of implied volatility for the options you are considering. Compare the level of implied volatility with the commonplace’s historical volatility and the level of volatility in the broad market, since this will be a key factor in identifying your choice trade/strategy.
Implied volatility lets you know whether other traders are expecting the stock to move a lot or not. Elevated implied volatility will push up premiums, making writing an option more attractive, assuming the trader supposes volatility will not keep increasing (which could increase the chance of the option being exercised). Low implied volatility indicates cheaper option premiums, which is good for buying options if a trader expects the underlying stock will motivate enough to increase the value of the options.
4. Identify Events
Events can be classified into two broad categories: market-wide and stock-specific. Market-wide consequences are those that impact the broad markets, such as Federal Reserve announcements and economic data releases. Stock-specific occasions are things like earnings reports, product launches, and spinoffs.
An event can have a significant effect on implied volatility previous to its actual occurrence, and the event can have a huge impact on the stock price when it does occur. So do you want to capitalize on the rush in volatility before a key event, or would you rather wait on the sidelines until things settle down?
Identifying anyway in the realities that may impact the underlying asset can help you decide on the appropriate time frame and expiration date for your recourse trade.
5. Devise a Strategy
Based on the analysis conducted in the previous steps, you now know your investment objective, demanded risk-reward payoff, level of implied and historical volatility, and key events that may affect the underlying asset. Going be means of the four steps makes it much easier to identify a specific option strategy.
For example, let’s say you are a conservative investor with a sizable supply portfolio and want to earn premium income before companies commence reporting their quarterly earnings in a match up of months. You may, therefore, opt for a covered call writing strategy, which involves writing calls on some or all of the stocks in your portfolio.
As another archetype, if you are an aggressive investor who likes long shots and is convinced that the markets are headed for a big decline within six months, you may reach to buy puts on major stock indices.
6. Establish Parameters
Now that you have identified the specific option strategy you impecuniousness to implement, all that remains is to establish option parameters like expiration dates, strike prices, and option deltas. For specimen, you may want to buy a call with the longest possible expiration but at the lowest possible cost, in which case an out-of-the-money telephone may be suitable. Conversely, if you desire a call with a high delta, you may prefer an in-the-money option.
ITM vs. OTM
An in-the-money (ITM) call has a thump price below the price of the underlying asset and an out-of-the-money (OTM) call option has a strike price above the price of the underlying asset.
Benchmarks Using these Steps
Here are two hypothetical examples where the six steps are used by different types of traders.
Say a rightist investor owns 1,000 shares of McDonald’s (MCD) and is concerned about the possibility of a 5%+ decline in the stock over the next few months. The investor does not fancy to sell the stock but does want protection against a possible decline:
- Objective: Hedge downside risk in course McDonald’s holding (1,000 shares); as of May 2022, the stock (MCD) is trading at $245.04.
- Risk/Reward: The investor does not mind a ungenerous risk as long as it is quantifiable, but is loath to take on unlimited risk.
- Volatility: Implied volatility on ITM put options (strike toll of $165) is 17.38% for one-month puts and 16.4% for three-month puts. Market volatility, as measured by the CBOE Volatility Guide (VIX), is 13.08%.
- Events: The investor wants a hedge that extends past McDonald’s earnings report. Earnings come out in well-deserved over two months, which means the options should extend about three months out.
- Strategy: Buy puts to hedge the hazard of a decline in the underlying stock.
- Option Parameters: Three-month $165-strike-price puts are available for $7.15.
Since the investor covets to hedge the stock position past earnings, they buy the three-month $165 puts. The total cost of the put position to hedge 1,000 allowances of MCD is $7,150 ($7.15 x 100 shares per contract x 10 contracts). This cost excludes commissions.
If the stock drops, the investor is hedged, as the advance on the put option will likely offset the loss in the stock. If the stock stays flat and is trading unchanged at $161.48 very immediately before the puts expire, the puts would have an intrinsic value of $3.52 ($165 – $161.48), which means that the investor could repay about $3,520 of the amount invested in the puts by selling the puts to close the position.
If the stock price goes up atop $165, the investor profits on the increase in value of the 1,000 shares but forfeits the $7,150 paid on the options.
Now, assume an belligerent trader is bullish on the prospects for Bank of America (BAC) and has $1,000 to implement an options trading strategy:
- Objective: Buy speculative phones on Bank of America. The stock is trading at $30.55.
- Risk/Reward: The investor does not mind losing the entire investment of $1,000, but wants to get as numberless options as possible to maximize potential profit.
- Volatility: Implied volatility on OTM call options (strike price of $32) is 16.9% for one-month collect summons and 20.04% for four-month calls. Market volatility as measured by the CBOE Volatility Index (VIX) is 13.08%.
- Events: None, the company hardly had earnings so it will be a few months before the next earnings announcement. The investor is not concerned with earnings right now, but have the courage of ones convictions pretends the stock market will rise over the next few months and believes this stock will do especially fount.
- Strategy: Buy OTM calls to speculate on a surge in the stock price.
- Option Parameters: Four-month $32 calls on BAC are available at $0.84, and four-month $33 draw ons are offered at $0.52.
Since the investor wants to purchase as many cheap calls as possible, they opt for the four-month $33 calls. Excluding commissions, 19 diminishes are bought or $0.52 each, for a cash outlay of $988 (19 x $0.52 x 100 = $988), plus commissions.
The maximum gain is theoretically limitless. If a global banking conglomerate comes along and offers to acquire Bank of America for $40 in the next couple of months, the $33 conscripts would be worth at least $7 each, and the option position would be worth $13,300. The breakeven point on the traffic is the $33 + $0.52, or $33.52.
If the stock is above $33.01 at expiration, it is in-the-money, has value, and will be subject to auto-exercise. However, the calls can be arranged at any time prior to expiration through a sell-to-close transaction.
Note that the strike price of $33 is 8% great than the stock’s current price. The investor must be confident that the price can move up by at least 8% in the next four months. If the honorarium isn’t above the $33 strike price at expiry, the investor will have lost the $988.
The Bottom Line
While the afield range of strike prices and expiration dates may make it challenging for an inexperienced investor to zero in on a specific option, the six journeys outlined here follow a logical thought process that may help in selecting an option to trade. Define your unbiased, assess the risk/reward, look at volatility, consider events, plan out your strategy, and define your options parameters.