Step 1: Define Your Trading Objective
Before beginning the journey of trading options, you must first define your trading objective.
What are you trying to accomplish with your trade?
Here are some common objectives and corresponding popular options strategies:
|OBJECTIVE||POPULAR OPTIONS STRATEGY|
|Speculate on a stock’s price direction||Long call (bullish) or long put (bearish)|
|Hedge potential downside risk||Long put|
|Earn income from selling option premium||Bull put spreads or covered calls|
|Profit from volatility surrounding a stocks earnings release||Long straddle|
Of course, there’s more, but these strategies are the best place to start. Moreover, narrowing your focus to a single objective will help you make the right decision on which option strategy to use.
Remember, options expire and therefore part of their value declines with the passage of time. And if you’re buying, you typically should not hold them to their expiration.
Finally, you should always establish a clear objective ahead of time. This will help you determine when it’s time to close your position.
Step 2: Determine Your Risk/Reward Payoff
Before you enter any trade, it is important that you understand your risk/reward profile. Successful traders will always understand this at the outset of every trade.
The risk/reward profile should be in line with your appetite for risk and your level of experience. If you are a conservative investor, then supercharged leverage may not be suited to you.
Some options strategies are in fact rather suitable for conservative investors. Regardless, every popular options strategy has a well-defined risk and reward profile, so make sure you understand it thoroughly.
Step 3: Understand the Impact of Volatility and Time Decay
The subject of volatility can command an entire book’s worth of content on its own.
Sadly, it is poorly understood and poorly taught by most so-called educators.
First, there are two types of volatility. One for the underlying stock’s past activity (historical volatility), and one for the expected volatility moving forward, which is priced into options premiums (implied volatility).
The bottom line is that you need to understand how volatility may affect your strategy. This can be remarkably easy provided you have the right toolkit in your possession.
For example, when buying a call or put, volatility is quite straightforward. It only affects the time value portion of the premium. So, if you buy deep in-the-money options where only a small portion of the premium is time value, then your exposure to implied volatility fluctuations will be small.
In simple terms, time decay hurts a long options position, and volatility helps it because greater volatility has the effect of increasing premium values.
Now, take a two legged strategy – like any vertical or horizontal spread – and the picture becomes more nuanced. But unless you can “see” it, you simply won’t be able to appreciate it.
Take for instance a popular strategy like a bull put spread, volatility helps the strategy when it’s losing, and hurts the strategy when it’s winning.
Conversely, time decay helps the strategy when it’s winning and hurts it when it’s losing.
And of course, the nuances become further nuanced with the passage of time.
The only way to appreciate this is to actually see it.
Step 4: Identify News
Identifying events that may impact the underlying stock can help you decide on the appropriate time frame and expiration date for your option trade.
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 (FED) announcements and economic data releases. Stock-specific events are things like earnings reports, product launches, and buyouts.
An event can have a significant upward effect on implied volatility before its actual occurrence due to perceived uncertainty, and the event can then have another huge impact on the stock price when it does actually occur.
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?
In the past, options were regularly mispriced due to the implied volatility part of the equation, giving experienced traders excellent opportunities. Nowadays, due to computerization, blatant implied volatility mispricing is much rarer and far more nuanced.
Step 5: Choose a Strategy
All traders are different when it comes to options trading strategies, and that’s ok!
Some traders use options to protect the value of their stock portfolios from a potential bearish event. Others use options for aggressive account growth. And using options to generate income is also a popular strategy.
Different strategies suit different trading needs and goals over different time horizons. For example, a 60-year-old retiree may have very different objectives compared to a 25-year-old who has just entered the workforce and is building their savings portfolio for retirement.
For many traders and investors, options are a wonderful investment tool that can help you achieve windfall profits or protect your assets. Just don’t try to cut corners. Take the time to understand what you’re doing first. It’s not rocket science, but it is important to know which strategies will suit your needs best.
For those of you considering adding options to your toolkit, use this five-step procedure to explore potential options strategies. Selecting the right one is an important part of the process, so don’t rush it.
If you are new to options, start with buying calls and puts first. Make sure you have a good grasp of how the strategy works before moving on to more advanced strategies.
For some traders, simple long calls and puts is enough, especially if they are good at predicting the moves, whether up or down, of the underlying assets. For others, it’s just the start of a fascinating and lucrative journey where there is opportunity at every corner.