Most Effective Way to Trade Options
Do you know how to trade options effectively? How can you be successfull? You need to considder several things like probabilities, undirend or defined risk strategies, liquid options, best time to sell options and the days to expiration.
We first look at probabilities. Buying stocks you only have 50 percent chance that you end up of making money. With options you have more possibilities. Let’s look at the odds against the buyer being correct. Attribute 50/50 odds to correctly choosing each of these three elements. If flip a coin and said “Heads I’m going to buy a call, and tails I’m going to buy a put, you have roughly about 50/50 chance of being correct. Picking the magnitude of that move is even harder. With stock options we can improve the odds of a winning trade.
How to Trading Effectively
Selling naked options has advantages and disadvantages too. The advantage is that the option seller is collecting premium at the point of sale. Selling options works in your advantage, it has a better break even. You have a better probabilty of profit. Out of the money options has a better chance to expire worthless. In other words you keep the premium in your pocket.
If the price of the underlying stays flat you can keep the premium. If it moves the disered direction you kan keep the premium too. Does moves just a little against you and does not reach the break even, you can keep a portion of the premium. Does it moves too fast than your position looses money.
The disadvantages is that if you sell a naked option then you could sustain serious losses if the trade goes against you. Therefor you broker reserves much capital called buying power reduction. You may choose less expensive options for this strategy or reduce the risk by using defined risk strategies.
Defined risk credit spreads
If you like you can reduce your risk in a trade, by using defined risk trades. A credit spread is a defined risk trade. A credit spread is simply selling an option at a certain strike price and then buying one further out of the money for protection. A spread is the simultaneous opening of two or more option positions that offset one another. The set up is short selling calls or puts and simultaneously buying a call or put further out of the money. The most important attribute of any spread is that it can reduce the risk. If you trade a spread you can mitigate some of the risk that you have involved with an offsetting long position. If you go one step further and say I’m never going to let the spread go all the way to expiration, technically if it moves against me I’m going to get out, you can mitigate your risk even more. You manage the trade early and take profits.
Choose Liquid Options
Another effective way to trade options is when you select an option to trade look for options that are highly liquid. These options has a high Implied Volatility. And options with high IV are more expensive than other options. You will receive more premium. Selling Out of the Money options has more chance of success or in other words a probability of profit.
When do you sell Options?
In selling options you want to have the most money for your bug. You want to wait at least that the options are expensive and have a high Implied Volatility. Choosing the right time to enter positions is important. The best time to sell options is when they are at a price etreme or it might be a few days before earning announcement and/or if you think the price is at a top sell an out of the money call or call spread. Do you think the price is at the bottem you may sell an out of the money put or put spread. If the price stays in a certain band you may sell an Iron Condor, that is selling a call and put spread together.
Research showed that selling liquid options which are out of the money, with high implied volatilty and 45 days to expiration has all the odds in their favor. The reason is to benefit from theta decay and have enough time to work for you.
When entering short premium trades, we look to put them on with 45. Today, we take a deeper look into why we do this.
The two main reasons that we lookwith 45 DTE is that past studies have shown it is a nice trade-off between risk (as measured by the number of days) and reward. It also gives us enough time so that if the position moves against us, we still have time for it to come back. Alternatively, if it is a winner from the beginning, we can early.