6 Ways To Make Better Options Trades

When it comes to buying options, most traders focus on the premium paid rather than the potential returns. While this is important information in terms of making a calculated trade, many options traders tend to lose sight of the probability of the market reaching and exceeding its position's strike. The average monthly range of the market number provides perspective on two important elements of an options trade: whether volatility is expanding or contracting and whether the market has a chance of reaching and exceeding the breakeven point of the position. Read on to learn more.

It is commonly said that the majority of options expire worthless. If that is a true statement and you are trading a position that is long premium (i.e. buying a call or a put), you need the market to have a chance of reaching a price that will make your option position profitable. When considering an option position, it is important to consider if it is probable that the market will reach that point. Just because the premium paid is cheap or underpriced does not make the trade a good one, especially if the market has little or no probability of reaching that goal.

Generally, it pays to look at a time frame of twice the length of the option position you are considering, and then break this up into two separate blocks of time. For example, if the option you are considering has three months of time to expiration, look at the average monthly range of the last three months, the three months prior to that and the last six months.

In certain markets and at certain times, by using the average monthly range to choose options strikes, we may find that the implied volatility has pushed the option premiums to unreasonable levels. This causes smaller traders to buy strikes that are too far out of the money, simply because they want to be in a given market and have limited capital.

In these cases, the use of the average monthly range should be telling you to either avoid that market, or to use a strategy that can get you closer to the current market price, such as a debit spread (bull call spread or bear put spread).