# 6 Ways To Make Better Options Trades

AAA
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.

## 1. What Is The Probability?

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.

## 2. Calculate The Average Monthly Range

To calculate the average monthly range, all you need is access to reliable historical prices. For any stock, you can get historical open, high, low and closing prices for a given date range. This will give you all the key numbers that will be used in the calculation - the high and the low for each trading day. To calculate this average for a given period of time, subtract the low from the high for each month to get that month's range. For the time frame, add up each month's range and divide by the number of months.

## 3. Select A Time Period

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.

## 4. Apply The Strategy

Using the Nasdaq 100 Trust (Nasdaq:QQQQ) as an example, we find that as of June 2007, the previous three months had an average range of \$2.55, the three months prior had an average monthly range of \$2.46 and the six months combined had an average range of \$2.51. Therefore, we should look for options that will perform within the confines of a \$2.50 move in a month. So, for a three-month time frame, you should look for something no more than \$7.50 out-of-the-money. If the QQQQ is trading at 46.50 in June and the August 48 calls are trading at 1.00, the top of the average monthly range takes us to 54. QQQQ would need to trade to 49.00 for us to break even on buying the 48 calls for 1.00.

## 5. Words Of Caution

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).

In certain market conditions, the debit spread gives the investor a limited risk position and gets closer to the current market than buying an option outright. In exchange, the investor sacrifices unlimited gains for a limited, but defined, maximum gain. This is often a favorable tradeoff, and will keep the investor grounded in the reality of what the market is more likely to do. The advantage of unlimited gains is normally only effective if the market were to make a rare historic move. (To learn more, read Option Spread Strategies.)

## More Slideshows

Related Articles

### Make Better Options Trades With The Average Monthly Range

We'll show you how to use the average monthly trading range to score better returns.

### Options Hazards That Can Bruise Your Portfolio

Learn the top three risks and how they can affect you on either side of an options trade.

### Stock Options: What's Price Got To Do With It?

A thorough understanding of risk is essential in options trading. So is knowing the factors that affect option price.

### A Guide Of Option Trading Strategies For Beginners

Options offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons.

### 10 Traits Of A Successful Options Trader

If you want to take advantage of the versatility of options, you'll need to adopt these smart investing habits and traits.

### Google Stock Too Expensive For You? Try Options

Investing in Google (GOOG) generally requires you to pay the price of the share multiplied by the number of shares bought. An alternative using lesser capital involves using options.
7. Personal Finance

### Top 5 Books to Become an Option Trader

For individuals aspiring to become options traders, here are five of the best books that offer help in understanding and profiting from the options markets.
Hot Definitions
1. ### Retirement Planning

Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
2. ### Drawdown

The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
3. ### Inverse Transaction

A transaction that can cancel out a forward contract that has the same value date.
4. ### Redemption

The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
5. ### Solvency

The ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business, but a ...
6. ### Dilution

A reduction in the ownership percentage of a share of stock caused by the issuance of new stock. Dilution can also occur ...