5 Steps to Choose the Right Stock Options
So, everyone's making money trading options and you are eager to make the move from good old boring stocks to options trading.
That's good, but ever since you started options trading, you are bombarded with the hundreds of options available on every stock and you can never seem to make the correct choice when it comes to choosing which particular option to trade.
This guide will teach you 5 simple steps to choose the correct stock options for options trading.
Step 1: Decide on the outlook of the underlying stock.
There is no magic formula in options trading where you can simply trade and profit without concern for the trend of the underlying instrument.
The first step to choosing the correct option to trade comes from what you expect the underlying stock to do in the first place.
There are generally only three outlooks in stock trading; bullish, bearish or neutral.
However, in order to optimize profits in options trading, there can be as many as six different outlooks; sustained bullish, moderately bullish, neutral, volatile, sustained bearish and moderately bearish.
You need to decide on which of these six outlooks most closely conform to your expectation on the underlying stock as each of these outlooks require a different options strategy to best optimize its profit potential.
Step 2: Decide on the time frame of that outlook.
Now that you have decided on what the underlying stock is going to do, the next question to answer is WHEN you think the underlying stock going to fulfill its expected outlook.
This answers the question of which expiration month to trade your options on.
One of the first things that baffle new options traders is the number of expiration months available for each stock.
Options are derivative instruments that expire once its lifespan is up.
It isn't like stocks which can last as long as the company remains in existence.
This makes choosing the correct expiration month so important.
Options become more and more expensive and less and less sensitive to movements in the underlying stock with longer expiration.
This is why trading options isn't as easy as simply trading options with the longest possible expiration.
If you trade options with unnecessarily long expiration, you are paying more for nothing and lowering your return on investment.
Conversely, if you trade options with too short expiration, you can end up with a worthless expired position even before the underlying stock has time to move according to your prediction.
As such, the more accurately you can predict when the underlying stock is going to behave the way it is expected to, the better you can optimize return on investment in options trading.
There are situations such as earnings releases or some major announcements where the exact timing of the outlook can be determined.
Other than such objective events, predicting when a stock is going to hit a certain price or remain within a price range requires extremely strong technical analysis skill and experience.
Step 3: Decide on the magnitude of that outlook.
The magnitude of an outlook refers to how strongly you expect the underlying stock to move in the expected direction.
In the case of an expected neutral trend, magnitude refers to the expected length of that neutral trend as well as how much volatility is expected within that neutral trend.
This is also why in options trading, bullish and bearish trends are classified as either sustained or moderate.
Knowing the magnitude of the outlook allows you to decide on the moneyness of the option that you should trade.
Moneyness refers to how much in the money or out of the money an option is.
The more in the money an option is, the more expensive it is, the lower the leverage but the better it is at capturing profits on small price movements of the underlying stock.
The more out of the money an option is, the cheaper it is, the higher the leverage and the less sensitive it is to price movements on the underlying stock, making them better for use when the expected magnitude of price movement is big.
Step 4: Decide on the optimal options strategy for your account level.
Now that you have an idea what the underlying stock might do, when it is going to do it and how powerful the movement might be, this is when you should decide on the optimal options strategy to profit from that move.
The optimal options strategy could be as simple as buying a call option or put option or as complex as a Double Butterfly Spread.
Your choice of options strategy would also be limited by your account trading level which defines the range of options strategy that you are allowed to perform.
This options account trading level is determined by your broker on an individual basis depending on your fund size and your trading experience.
Step 5: Decide on the exact option to trade taking all of the above into consideration.
Having taken all of the above factors into consideration, you would then be able to decide on the exact correct option to trade.
Here's an example of how it works: Assuming it is January now and the price of a stock is $50.
Assuming you think the price of that stock is going to move upwards but only moderately up to $55 by next month.
You decided that this is a moderately bullish outlook which can be better optimized using a Bull Call Spread, writing out of the money call options on the expected price ceiling on at the money call options, rather than just buying in the money call options and your account trading level allows you to execute such debit spreads.
Taking all of these factors into consideration, you decided to execute a 50/55 bull call spread on that stock's March expiration options, giving a little bit more time for the stock to move to that expected price.
Just follow these five simple steps and you will always be able to find the correct options to trade like an options pro!
That's good, but ever since you started options trading, you are bombarded with the hundreds of options available on every stock and you can never seem to make the correct choice when it comes to choosing which particular option to trade.
This guide will teach you 5 simple steps to choose the correct stock options for options trading.
Step 1: Decide on the outlook of the underlying stock.
There is no magic formula in options trading where you can simply trade and profit without concern for the trend of the underlying instrument.
The first step to choosing the correct option to trade comes from what you expect the underlying stock to do in the first place.
There are generally only three outlooks in stock trading; bullish, bearish or neutral.
However, in order to optimize profits in options trading, there can be as many as six different outlooks; sustained bullish, moderately bullish, neutral, volatile, sustained bearish and moderately bearish.
You need to decide on which of these six outlooks most closely conform to your expectation on the underlying stock as each of these outlooks require a different options strategy to best optimize its profit potential.
Step 2: Decide on the time frame of that outlook.
Now that you have decided on what the underlying stock is going to do, the next question to answer is WHEN you think the underlying stock going to fulfill its expected outlook.
This answers the question of which expiration month to trade your options on.
One of the first things that baffle new options traders is the number of expiration months available for each stock.
Options are derivative instruments that expire once its lifespan is up.
It isn't like stocks which can last as long as the company remains in existence.
This makes choosing the correct expiration month so important.
Options become more and more expensive and less and less sensitive to movements in the underlying stock with longer expiration.
This is why trading options isn't as easy as simply trading options with the longest possible expiration.
If you trade options with unnecessarily long expiration, you are paying more for nothing and lowering your return on investment.
Conversely, if you trade options with too short expiration, you can end up with a worthless expired position even before the underlying stock has time to move according to your prediction.
As such, the more accurately you can predict when the underlying stock is going to behave the way it is expected to, the better you can optimize return on investment in options trading.
There are situations such as earnings releases or some major announcements where the exact timing of the outlook can be determined.
Other than such objective events, predicting when a stock is going to hit a certain price or remain within a price range requires extremely strong technical analysis skill and experience.
Step 3: Decide on the magnitude of that outlook.
The magnitude of an outlook refers to how strongly you expect the underlying stock to move in the expected direction.
In the case of an expected neutral trend, magnitude refers to the expected length of that neutral trend as well as how much volatility is expected within that neutral trend.
This is also why in options trading, bullish and bearish trends are classified as either sustained or moderate.
Knowing the magnitude of the outlook allows you to decide on the moneyness of the option that you should trade.
Moneyness refers to how much in the money or out of the money an option is.
The more in the money an option is, the more expensive it is, the lower the leverage but the better it is at capturing profits on small price movements of the underlying stock.
The more out of the money an option is, the cheaper it is, the higher the leverage and the less sensitive it is to price movements on the underlying stock, making them better for use when the expected magnitude of price movement is big.
Step 4: Decide on the optimal options strategy for your account level.
Now that you have an idea what the underlying stock might do, when it is going to do it and how powerful the movement might be, this is when you should decide on the optimal options strategy to profit from that move.
The optimal options strategy could be as simple as buying a call option or put option or as complex as a Double Butterfly Spread.
Your choice of options strategy would also be limited by your account trading level which defines the range of options strategy that you are allowed to perform.
This options account trading level is determined by your broker on an individual basis depending on your fund size and your trading experience.
Step 5: Decide on the exact option to trade taking all of the above into consideration.
Having taken all of the above factors into consideration, you would then be able to decide on the exact correct option to trade.
Here's an example of how it works: Assuming it is January now and the price of a stock is $50.
Assuming you think the price of that stock is going to move upwards but only moderately up to $55 by next month.
You decided that this is a moderately bullish outlook which can be better optimized using a Bull Call Spread, writing out of the money call options on the expected price ceiling on at the money call options, rather than just buying in the money call options and your account trading level allows you to execute such debit spreads.
Taking all of these factors into consideration, you decided to execute a 50/55 bull call spread on that stock's March expiration options, giving a little bit more time for the stock to move to that expected price.
Just follow these five simple steps and you will always be able to find the correct options to trade like an options pro!
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