Options can be used to implement a big selection of trading strategies, starting from easy buy and sells to complex spreads with names like butterflies and condors. As well as, options are available on an unlimited range of stocks, currencies, commodities, exchange-traded funds, and futures contracts.

There are sometimes dozens of strike prices and expiration dates available for every asset, which might pose a challenge to the choice novice since the plethora of decisions available makes it sometimes difficult to discover an acceptable choice to trade. 

Finding the Right Option

We start with the belief that you might have already identified a financial asset—akin to a stock, commodity, or ETF—that you simply want to trade using options. You will have picked this underlying using a stock screener, by employing your individual evaluation, or by utilizing third-party research. No matter the tactic of selection, once you might have identified the underlying asset to trade, there are the six steps for locating the fitting option:

1. Formulate your investment objective.
2. Determine your risk-reward payoff.
3. Check the volatility.
4. Discover events.
5. Devise a method.
6. Establish option parameters.

The six steps follow a logical thought process that makes it easier to select a particular option for trading. Let’s breakdown what each of those steps involves.

1. Option Objective

The place to begin when making any investment is your investment objective, and options trading isn’t any different. What objective do you desire to achieve together with your option trade? Is it to take a position on a bullish or bearish view of the underlying asset? Or is it to hedge potential downside risk on a stock wherein you might have a major position?

Are you putting on the trade to earn income from selling option premium? For instance, is the strategy a part of a covered call against an existing stock position or are you writing puts on a stock that you desire to own? Using options to generate income is a vastly different approach in comparison with buying options to take a position or to hedge.

Your first step is to formulate what the target of the trade is, since it forms the inspiration for the following steps. 

2. Risk/Reward

The following step is to find out your risk-reward payoff, which must be depending on your risk tolerance or appetite for risk. In case you are a conservative investor or trader, then aggressive strategies akin to writing puts or buying a considerable amount of deep out of the cash (OTM) options may not be suited to you. Every option strategy has a well-defined risk and reward profile, so make sure that you understand it thoroughly.

3. Check the Volatility

Implied volatility is one of the vital necessary determinants of an option’s price, so get a superb read on the extent of implied volatility for the choices you might be considering. Compare the extent of implied volatility with the stock’s historical volatility and the extent of volatility within the broad market, since this can be a key consider identifying your option trade/strategy.

Implied volatility lets you understand whether other traders expect the stock to maneuver loads or not. High implied volatility will push up premiums, making writing an option more attractive, assuming the trader thinks volatility is not going to keep increasing (which could increase the possibility of the choice being exercised). Low implied volatility means cheaper option premiums, which is sweet for purchasing options if a trader expects the underlying stock will move enough to extend the worth of the choices.

4. Discover Events

Events could be classified into two broad categories: market-wide and stock-specific. Market-wide events are people who impact the broad markets, akin to Federal Reserve announcements and economic data releases. Stock-specific events are things like earnings reports, product launches, and spinoffs.

An event can have a major effect on implied volatility before its actual occurrence, and the event can have a huge effect on the stock price when it does occur. So do you desire to capitalize on the surge in volatility before a key event, or would you quite wait on the sidelines until things cool down?

Identifying events which will impact the underlying asset can provide help to settle on the suitable time-frame and expiration date on your option trade.

5. Devise a Strategy

Based on the evaluation conducted within the previous steps, you now know your investment objective, desired risk-reward payoff, level of implied and historical volatility, and key events which will affect the underlying asset. Going through the 4 steps makes it much easier to discover a particular option strategy.

For instance, let’s say you might be a conservative investor with a large stock portfolio and wish to earn premium income before corporations start reporting their quarterly earnings in a few months. You could, subsequently, go for a covered call writing strategy, which involves writing calls on some or the entire stocks in your portfolio.

As one other example, in case you are an aggressive investor who likes long shots and is convinced that the markets are headed for an enormous decline inside six months, chances are you’ll determine to purchase puts on major stock indices.

6. Establish Parameters

Now that you might have identified the particular option strategy you desire to implement, all that is still is to determine option parameters like expiration dates, strike prices, and option deltas. For instance, chances are you’ll wish to buy a call with the longest possible expiration but at the bottom possible cost, wherein case an out-of-the-money call could also be suitable. Conversely, in case you desire a call with a high delta, chances are you’ll prefer an in-the-money option.

Examples Using these Steps

Listed here are two hypothetical examples where the six steps are utilized by various kinds of traders.

Say a conservative investor owns 1,000 shares of McDonald’s (MCD) and is worried about the opportunity of a 5%+ decline within the stock over the following few months. The investor doesn’t wish to sell the stock but does want protection 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 doesn’t mind slightly risk so long as it’s quantifiable, but is loath to tackle 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 only over two months, which implies the choices should extend about three months out.
• Strategy: Buy puts to hedge the chance of a decline within the underlying stock.
• Option Parameters: Three-month $165-strike-price puts can be found for $7.15.

For the reason that investor desires to hedge the stock position past earnings, they buy the three-month $165 puts. The entire 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, because the gain on the put option will likely offset the loss within 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 implies that the investor could recoup about $3,520 of the quantity invested within the puts by selling the puts to shut the position.

If the stock price goes up above $165, the investor profits on the rise in value of the 1,000 shares but forfeits the $7,150 paid on the choices.

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 doesn’t mind losing your entire investment of $1,000, but desires to get as many options as possible to maximise 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 corporate just had earnings so it is going to be just a few months before the following earnings announcement. The investor shouldn’t be concerned with earnings at once, but believes the stock market will rise over the following few months and believes this stock will do especially well.
• Strategy: Buy OTM calls to take a position on a surge within the stock price.
• Option Parameters: 4-month $32 calls on BAC can be found at $0.84, and four-month $33 calls are offered at $0.52.

For the reason that investor desires to purchase as many low cost calls as possible, they go for the four-month $33 calls. Excluding commissions, 19 contracts are bought or $0.52 each, for a money outlay of $988 (19 x $0.52 x 100 = $988), plus commissions.

The utmost gain is theoretically infinite. If a worldwide banking conglomerate comes along and offers to accumulate Bank of America for $40 in the following couple of months, the $33 calls could be price at the least $7 each, and the choice position could be price $13,300. The breakeven point on the trade is the $33 + $0.52, or $33.52.

Note that the strike price of $33 is 8% higher than the stock’s current price. The investor should be confident that the value can move up by at the least 8% in the following 4 months. If the value is not above the $33 strike price at expiry, the investor may have lost the $988.

The Bottom Line

While the big selection of strike prices and expiration dates may make it difficult for an inexperienced investor to zero in on a particular option, the six steps outlined here follow a logical thought process which will assist in choosing an choice to trade. Define your objective, assess the chance/reward, take a look at volatility, consider events, plan out your strategy, and define your options parameters.