Options can be used to implement a wide array of trading strategies, ranging from simple buy and sells to complex spreads with names like butterflies and condors. In addition, options are available on a vast range of stocks, currencies, commodities, exchange-traded funds, and futures contracts.
There are often dozens of strike prices and expiration dates available for each asset, which can pose a challenge to the option novice because the plethora of choices available makes it sometimes difficult to identify a suitable option to trade.
- Options trading can be complex, especially since several different options can exist on the same underlying, with multiple strikes and expiration dates to choose from.
- Finding the right option to fit your trading strategy is therefore essential to maximize success in the market.
- There are six basic steps to evaluate and identify the right option, beginning with an investment objective and culminating with a trade.
- Define your objective, evaluate the risk/reward, consider volatility, anticipate events, plan a strategy, and define options parameters.
Finding the Right Option
We start with the assumption that you have already identified a financial asset—such as a stock, commodity, or ETF—that you wish to trade using options. You may have picked this underlying using a stock screener, by employing your own analysis, or by using third-party research. Regardless of the method of selection, once you have identified the underlying asset to trade, there are the six steps for finding the right option:
- Formulate your investment objective.
- Determine your risk-reward payoff.
- Check the volatility.
- Identify events.
- Devise a strategy.
- Establish option parameters.
The six steps follow a logical thought process that makes it easier to pick a specific option for trading. Let's breakdown what each of these steps involves.
1. Option Objective
The starting point when making any investment is your investment objective, and options trading is no different. What objective do you want to achieve with your option trade? Is it to speculate on a bullish or bearish view 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 trade to earn income from selling option premium? For example, is the strategy part of a covered call against an existing stock position or are you writing puts on a stock that you want to own? Using options to generate income is a vastly different approach compared to buying options to speculate or to hedge.
Your first step is to formulate what the objective of the trade is, because it forms the foundation for the subsequent steps.
The next step is to determine your risk-reward payoff, which should be dependent on your risk tolerance or appetite for risk. If you are a conservative investor or trader, then aggressive strategies such as writing puts or buying 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 profile, so make sure you understand it thoroughly.
3. Check the Volatility
Implied volatility is one of the most important determinants of an option’s price, 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 stock’s historical volatility and the level of volatility in the broad market, since this will be a key factor in identifying your option trade/strategy.
Implied volatility lets you know whether other traders are expecting the stock to move a lot or not. High implied volatility will push up premiums, making writing an option more attractive, assuming the trader thinks volatility will not keep increasing (which could increase the chance of the option being exercised). Low implied volatility means cheaper option premiums, which is good for buying options if a trader expects the underlying stock will move 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 events are those that impact the broad markets, such as Federal Reserve announcements and economic data releases. Stock-specific events are things like earnings reports, product launches, and spinoffs.
An event can have a significant effect on implied volatility before 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 surge in volatility before a key event, or would you rather wait on the sidelines until things settle down?
Identifying events that may impact the underlying asset can help you decide on the appropriate time frame and expiration date for your option trade.
5. Devise a Strategy
Based on the analysis conducted in the previous steps, you now know your investment objective, desired risk-reward payoff, level of implied and historical volatility, and key events that may affect the underlying asset. Going through 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 stock portfolio and want to earn premium income before companies commence reporting their quarterly earnings in a couple 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 example, 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 decide to buy puts on major stock indices.
6. Establish Parameters
Now that you have identified the specific option strategy you want to implement, all that remains is to establish option parameters like expiration dates, strike prices, and option deltas. For example, 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 call 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 strike 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.
Examples Using these Steps
Here are two hypothetical examples where the six steps are used by different types of traders.
Say a conservative 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 want to sell the stock but does want to protect himself against a possible decline:
- Objective: Hedge downside risk in current McDonald’s holding (1,000 shares); the stock (MCD) is trading at $161.48.
- Risk/Reward: The investor does not mind a little risk as long as it is quantifiable, but is loath to take on unlimited risk.
- Volatility: Implied volatility on ITM put options (strike price of $165) is 17.38% for one-month puts and 16.4% for three-month puts. Market volatility, as measured by the CBOE Volatility Index (VIX), is 13.08%.
- Events: The investor wants a hedge that extends past McDonald’s earnings report. Earnings come out in just over two months, which means the options should extend about three months out.
- Strategy: Buy puts to hedge the risk of a decline in the underlying stock.
- Option Parameters: Three-month $165-strike-price puts are available for $7.15.
Since the investor wants 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 shares 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 gain 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 shortly before the puts expire, the puts would have an intrinsic value of $3.52 ($165 - $161.48), which means that the investor could recoup about $3,520 of the amount invested in the puts by selling the puts to close the position.
If the stock price goes up above $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 aggressive trader is bullish on the prospects for Bank of America (BAC) and has $1,000 to implement an options trading strategy:
- Objective: Buy speculative calls 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 many options as possible to maximize potential profit.
- Volatility: Implied volatility on OTM call options (strike price of $32) is 16.9% for one-month calls and 20.04% for four-month calls. Market volatility as measured by the CBOE Volatility Index (VIX) is 13.08%.
- Events: None, the company just had earnings so it will be a few months before the next earnings announcement. The investor is not concerned with earnings right now, but believes the stock market will rise over the next few months and believes this stock will do especially well.
- 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 calls 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 contracts 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 infinite. If a global banking conglomerate comes along and offers to acquire Bank of America for $40 in the next couple of months, the $33 calls would be worth at least $7 each, and the option position would be worth $13,300. The breakeven point on the trade 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 closed at any time prior to expiration through a sell-to-close transaction.
Note that the strike price of $33 is 8% higher 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 price isn't above the $33 strike price at expiry, the investor will have lost the $988.
The Bottom Line
While the wide range of strike prices and expiration dates may make it challenging for an inexperienced investor to zero in on a specific option, the six steps outlined here follow a logical thought process that may help in selecting an option to trade. Define your objective, assess the risk/reward, look at volatility, consider events, plan out your strategy, and define your options parameters.