Pick The Right Options Trade
This article will help you to pick the right options trade. We will show you how to select an option trade with high probability of success. Picking the right option can be a tough decision, if you don’t know how.
And it often makes the difference between a good trade and a bad one. Option trading involves risk, and you can make a lot of money with taking more risk and get more profit or you choose to have less risk and profit.
Is there a safe way to take profits constantly without taking too much risks so that your trading account will grow steady?
How to select an option trade
If you want to select the right kind of trade you have to answer several questions. How much capital do you have? What options do you want to trade? What risk do you want to take? Which strategy are you going to use? How much capital may each trade tie up? Do you buy or sell options. And when do you exit the trade?
Buying or selling options
Can you guess both the direction and timing? An option buyer who want to make profit has not only to predict the direction of the market but also the magnitude of the move. The question also is How fast will the market get to your target? Will it take 3 days or 6 months? In the world of options trading just 1 day can make the difference between profits and losses. If someone bought an option at the strike that he thought the underlying security will move to, he is most likely to lose money because he paid premium for the options time value. If he was right about the direction but dead wrong about the timing – he lost.
Therefore we like to be on the other side. We sell premium, you can receive a profit when you sell options. When the stock doesn’t move over time you can buy the option back for a lower price. If the stocks moves the other way than the strike price the option value will drop. Does it move towards your strike it only cost your money if it is above the strike price plus the premium you have received. In the process of selecting an option trade I would choose to sell option premium gives me and you an extra edge. You don’t have to be right on the direction and still can make money. If you want to watch a video about premium selling watch this video How Selling Premium Works When Trading Options
Which options do you trade
First of all it is important to choose options which are liquid. It means many shares are traded. Make a list of stocks which are interesting to you. Write down as well stocks you don’t like. Look for stocks which have options. Enter these stocks in your Trading List. Follow these stocks for a while to get a feeling how they trade. Decide what stocks you want to Trade.
When trading options we look in the first place for stocks with a high Implied Volatility. Options which are moving much have more premium. We like to select options in which we can sell options with enough premium.
Buying an option is not so difficult but selling one could be another story. You only want to trade options which are very liquid. We like to select an option trade which allows us easily to enter and exit a trade. It will also ensure that you get the best possible price. You can recognize liquid options by their bid/ask spreads. The price between the bid and ask should not be more than six cents.
How much capital
Not everyone is going to have the same amount of money to start with. The amount of money you have is the size of your trading capital. This will determine the position size that you are able to trade with.
The position size is essentially the amount of money you put into the market – in other words the amount that you trade. The larger the position size, the more money you will make if the trade wins. However, this also means you can lose more money. This is why using the correct position size is so important, because you can keep within the correct limits of money management and protect your capital from losing trades.
As you probably already know is that you should never risk more than 2-4% of your trading account on any single trade, which is why your trading capital will determine how much money you can trade with. And you want to be in the game with at least 5 to 10 trades. Trading small and trade often is important to let the statistics work. Put up enough number of occurrences so that your portfolio has a steady grow.
What risk do you want
Depending on your capital in your portfolio your trading style could be different. With much capital you can afford to take more risk. With a small capital on the other end you want to be very cautious with your trades. You want to have the highest number of winning trades and still earn a decent profit. There is a little bit tension here. A higher winning rate means less risk and it also means less profit.
How do you select an option trade depends on the risk you are willing to take. For novice trades I would suggest to place low risk or defined risk trades. Low risk trades are all forms of spreads e.g. call spread, put spread, and Iron Condors.
When you choose to use undefined risk strategies you choose to sell naked options or strategies like Strangles. By selecting the proper strike price you can choose the risk you take. If you want to win 84% of your trades than you have to enter trades with options which have no more than 16 Delta. Your profit is higher when you choose to sell a Straddle, but your risk is higher too.
How to choose strategy
If you are new to trading you better choose defined risk strategies, your profit will be lower but you better choose a trading style with fits with your experience and your budget (portfolio) Of course you can trade with more risk and have better profits but then you might want to choose stock options which are not expensive.
For a better return of investment you can select trades with an undefined risk. Most of the times it means that your risk is 2x Standard Deviation. It is the same amount of buying power reduction, that is the amount of money the broker blocks on your account during the trade. If you like to earn more profits you can sell naked options. Do this only with cheap stocks. Be sure you can afford to buy the stocks when you get assigned. And never trade to much contracts.
How to pick the right expiration month
When you sell options, you’re selling time for the stock to do something. The more time you sell, the more expensive the option. You want to select an option trade where you can collect enough premium. We have discovered that 45 days to expiration is the sweet spot for selling options.
Read also about this topic how-to-trade-stock-options
If you want to succeed in trading you need to tread it as a business. And like all businesses they have a trading plan. It is the basis for selling option premium and making consistent profits.