After you have picked out which underlying asset to trade, it’s sometimes difficult to find out which option strategy is the best. In this article, we’ll give you the key steps in choosing which option is the most ideal to trade.
Your Investment Goal
Determining the reason why you are investing, or investment goal, is the first step in any kind of investing.
Be clear about your objectives and what you want to achieve in investing in options. Do you have a positive or negative view of the underlying asset? Are you going to use it as a hedge for the potential downside risk on an asset in which you have a large position? Do you want to earn premium on the trade?
Determining your goals is the foundation of any trading strategy.
Risk/Reward Tradeoff
Afterwards, you can determine your risk/reward payoff, which has something to do with your risk tolerance or your appetite for risk. If you are a conservative investor or trader, you may want to steer away from aggressive strategies like writing naked calls or buying a large amount of deep out of the money (OTM).
Every option strategy has a well-defined risk and reward profile, so make sure that you understand it thoroughly.
Volatility
Get to know what implied volatility is, since it is the most crucial determinant of an option’s price. Implied volatility enables you to know whether other traders are anticipating a huge upward movement on the stock (or any underlying asset) or not.
Compare the level of implied volatility with the stock’s historical volatility and the level of volatility in the broad market. This will be a crucial point in finding your option strategy.
High implied volatility means premiums will go higher, making writing an option more ideal, assuming that you don’t think volatility will keep increasing. Low implied volatility, on the other hand, means less expensive option premiums, which is good for buying options if a trader expects the underlying stock will move enough to put the option in the money (ITM).
Events
Events can either be market-wide or stock-specific. As the name suggests, market-wide events affect the broader market, such as Federal Reserve announcements and economic releases. Meanwhile, stock-specific events are events like earnings reports, mergers and acquisitions, and spinoffs.
An event can have a huge impact 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.
Spotting events that may affect the underlying asset can help you decide on the appropriate expiration for your option trade.
Strategy
Take all the above mentioned steps together and use them to determine the strategy you will use with the trade.
For instance, suppose you are a conservative investor with a sizable stock portfolio. You want to earn a premium income before companies commence reporting their quarterly earnings in a couple of months. Thus, you may choose a covered call strategy, which involves writing calls on some or all of the stocks in your portfolio.
Parameters
Your last step is to establish the options parameters such as expiration, strike price, and option delta. For example, you may want an option that has the longest possible expiration but with a low price, so you opt for an OTM call.