Options refer to the contracts that give you the right to buy or sell an underlying asset- this asset could be a stock, commodities, currencies, exchange-traded funds, or other assets based on the market movements within a certain time. If you are a smart trader who likes to rely on data and on your gut feeling, then this is a great place to start. Options trading will give you a chance to benefit from the stock price fluctuations and get a multiplied return value. Other than the plain buy and sell strategies, you can also make use of other strategies such as butterflies and condors. Many options come with expiration dates and strike prices with each asset, making it difficult for investors to decide and choose which option to trade. In this article, we will discuss different trading options and how to pick the right one.
Once you have figured out which underlying asset you want to trade on, you need to follow a few steps to find the right option for yourself.
1. Option Objective
It is extremely important to understand why you want to invest. When it comes to options trading, you need to make your objectives clearer. Do you want to generate income through selling? What do you aim to achieve with your options trade? Are you looking to take a chance on the bearish view of the underlying asset, or do you want to hedge potential risk on an asset? It is essential to understand the objective as it will pave the way for the other steps.
Each option strategy has a clear and well-defined risk and reward profile. You must take the time to understand it properly, as it will help you navigate how much risk you’re willing to take. If you are a traditional trader, then strategies like buying a great volume of out-of-the-money (OTM) options may not be the best decision for you.
3. Check the Volatility
Understanding the implied volatility for the option you’re considering is extremely crucial. Implied volatility refers to an indicator that depicts a market’s understanding of the likelihood of changes in the price of a security. Many traders use strategies to learn about trends like the shorter moving average that helps them look at the bigger picture and understand which trading approach to take. You must take the time to compare the implied volatility of an asset with the level of volatility in the market and its historical volatility to identify your option trade strategy.
4. Identify Events
When it comes to options trading, the events can be categorized into two categories: Stock-specific and market-wide. The stock-specific events refer to the events like product launches, earnings reports, spinoffs, etc. Whereas market-wide events are those that have a significant impact on the markets, such as the economic data releases or the federal reserve announcements. The events can also affect the implied volatility greatly before they even occur and it has a major influence on the stock prices when it does occur. This is why it is important to understand the impact of events on your underlying assets. They will help you make decisions regarding the expiration date for your options trade or the appropriate time frame.
5. Devise a Strategy
Once you have carefully analyzed the previous steps, it will become quite easy for you to devise an option strategy that would allow you to maximize your returns. You can opt for the writing strategy if you have an impressive stock portfolio and consider yourself a conservative investor who wants to earn premium income before the companies start presenting their quarterly earnings. The writing strategy will require you to write calls on stocks in your portfolio that you want. On the other hand, if you are an aggressive investor who likes to take risks and believe that the specific stock market is going to decline in the coming months, then you may want to buy puts on major stock indices.
6. Establish Parameters
Now that you have followed all steps and devised your strategy, it is time for you to set other parameters such as the stock time frame, expiration date, option deltas, strike prices, etc. For example, if you want to make a call with a high delta, then you may want to go for an in-the-money option.
If you are new to the world of options trading, then following the six steps given above will help you understand everything ranging from strike prices to expiration dates. These steps will help you carefully choose an option to trade. It is extremely important to identify your objective, identify the risk and reward, consider the implied volatility, study events, carefully curate a strategy, and define the parameters for your options trading.