Two major benefits of options are a the extensive range of options available, and b their inherent versatility that allows any conceivable trading strategy to be implemented. Options are currently offered on a vast range of stocks, currencies, commodities, exchange-traded funds and other financial instruments ; on each single asset, there are generally dozens of strike prices and expiration dates available.
But these same advantages also pose a challenge to the option neophyte, 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.
Or it may simply be a stock or fund about which you have a strong opinion. Once you have identified the underlying asset , the six steps required to identify a suitable option are as follows:. In my opinion, the order shown of the six steps follows a logical thought process that makes it easier to pick a specific option for trading. Bateman does not mind a little risk as long as it is quantifiable, but is loath to take on unlimited risk.
Buy puts to hedge the risk of a decline in the underlying stock. The four-month calls expire in January, and Robin thinks the tendency of equity markets to finish the year on a strong note will benefit BAC and her option position. The maximum gain is theoretically infinite. 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.
The author did not own any of the securities mentioned in this article at the time of publication. Dictionary Term Of The Day. A conflict of interest inherent in any relationship where one party is expected to Broker Reviews Find the best broker for your trading or investing needs See Reviews. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. A celebration of the most influential advisors and their contributions to critical conversations on finance.
Become a day trader. The Six Steps 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. Once you have identified the underlying asset , the six steps required to identify a suitable option are as follows: Formulate your investment objective Determine your risk-reward payoff Check out volatility Identify events Devise a strategy Establish option parameters In my opinion, the order shown of the six steps follows a logical thought process that makes it easier to pick a specific option for trading.
A step-by-step guide to picking an option Objective: 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 some premium income?
Whatever your specific objective, your first step should be to formulate it because it forms the foundation for the subsequent steps. The next step is to determine your risk-reward payoff, which is very 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 really be suited to you. Every option strategy has a well-defined risk and reward profile, so make sure you understand it thoroughly. 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, while stock-specific events are things like earnings reports, product launches and spin-offs. Note that we only consider expected events here, since unexpected events are by definition unpredictable and thus impossible to factor in a trading strategy.
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. This is the penultimate step in picking an option.
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.
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 deeply OTM puts on major stock indices.
Now that you have identified the specific option strategy you want to implement, all that remains to be done is 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. Examples We run through these six steps in a couple of examples below. The Bottom Line 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.
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