Pick The Right Options To Trade In Six Steps

Options can be used to implement a wide array of trading strategies, ranging from plain-vanilla call/put buying or writing, to bullish/bearish spreads, calendar spreads and ratio spreads, straddles, and strangles. Options are offered on a vast range of stocks, currencies, commodities, exchange-traded funds and other financial instruments. On each asset there are generally dozens of strike prices and expiration dates available. But these same advantages also pose a challenge to the option novice, since the plethora of choices available makes it difficult to identify a suitable option to trade. 

We start with the assumption that you have already identified the financial asset—such as a stock or ETF—you wish to trade using options. You may have picked this “underlying” asset in a variety of ways, such as using a stock screener, by employing your own analysis, or using third-party research. Once you have identified the underlying asset to trade, here are the six steps for finding the right option.

1. Formulate your investment objective.
2. Determine your risk-reward payoff.
3. Check the volatility.
4. Identify events.
5. Devise a strategy.
6. 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 is.

The starting point when making any investment is your investment objective, and option 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 premium income?

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 is dependent on your risk tolerance or appetite for risk. If you are a conservative investor or trader, then aggressive strategies such as writing naked calls 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.

Implied volatility is the most important determinant 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 put the option in (further in) in the money (ITM).

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 in the run-up to its actual occurrence, and 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 expiration for your option trade.

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 stock. This makes it much easier to identify a specific option strategy. 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 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 are convinced that the markets are headed for a big decline within six months, you may decide to buy OTM puts on major stock indices.

Now that you have identified the specific option strategy you want to implement, all that remains is to establish option parameters like expiration, strike price, and option delta. For example, you may want to buy a call with the longest possible expiration but at the lowest possible cost, in which case an OTM call may be suitable. Conversely, if you desire a call with a high delta, you may prefer an ITM option.

Here are two examples where the six steps are used by different types of traders.

1. Bateman, a conservative investor, owns 1,000 shares of McDonalds (MCD) and is concerned about the possibility of a 5%+ decline in the stock over the next few months. He doesn't 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: Bateman 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: Bateman desires a hedge that extends past McDonald’s earnings report. Earnings come out in just over two months, which means Bateman will need to get option that extends about three months out.

Strategy: Buy puts to hedge the risk of a decline in the underlying stock.

Option Parameters: Three month puts $165 strike price puts are available for $7.15.

Since Bateman wants to hedge his MCD position past earnings, he goes for 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, Bateman is hedged, as the gain on the option will offset the loss in the stock. If the stock stays flat and is trading unchanged at $161.48 very shortly before the puts expire, they would have an intrinsic value of $3.52 ($165 - $161.48), which means that Bateman could recoup about $3,520 of the amount invested in the puts by selling them. If the stock price goes up above $165, Bateman profits on his 1,000 shares, but forfeits the $7,150 paid on the options

2. Aggressive trader Robin is bullish on the prospects for Bank of America (BAC). She has $1,000 to implement on an option trading strategy.

Objective: Buy speculative calls on Bank of America. The stock is trading at $30.55.

Risk/Reward: Robin does not mind losing her entire investment of $1,000, but wants to get as many options as possible to maximize her 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. Robin is not concerned with earnings right now. Rather, she 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 Robin wants to purchase as many cheap calls as possible, she opts for the four-month $33 calls. Excluding commissions, she can buy 19 contracts (19 x $0.52 x 100 = $988).

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 Robin’s option position would be worth $13,300. The breakeven point on the trade is the $33 + $0.52, or $33.52. If the price isn't above that at expiry, Robin will have lost the $1,000.

Note that the strike price of $33 is 8% higher than the stock’s current price. Robin has to be pretty confident that the price can move up by at least 8% in the next four months.

While the wide range of strike prices and expirations 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.

Disclosure: The author did not own any of the securities mentioned in this article at the time of publication.