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Pick the Right Options to Trade in Six Steps
Options can be used to implement a wide array of trading strategies, ranging from plain-vanilla call/put buying or writing, to bullish/bearish spreads, calendar spreads and ratio spreads, straddles, and strangles. Options are offered on a vast range of stocks, currencies, commodities, exchange-traded funds and other financial instruments. On each asset there are generally dozens of strike prices and expiration dates available. But these same advantages also pose a challenge to the option novice, since the plethora of choices available makes it difficult to identify a suitable option to trade.
- Options trading can be complex, especially since several different options can exist on the same underlying, with multiple strikes and expirations.
- Finding the right option to fit your trading strategy is therefore essential to maximize success in the market.
- Here we define 6 basic steps to evaluate and identify the right option, beginning with an investment objective and culminating with a trade.
Finding the Right Option
We start with the assumption that you have already identified the financial asset—such as a stock or ETF—you wish to trade using options. You may have picked this “underlying” asset in a variety of ways, such as using a stock screener, by employing your own analysis, or using third-party research. Once you have identified the underlying asset to trade, here are the six steps for finding the right option.
- Formulate your investment objective.
- Determine your risk-reward payoff.
- Check the volatility.
- Identify events.
- Devise a strategy.
- Establish option parameters.
The six steps follow a logical thought process that makes it easier to pick a specific option for trading. Let’s breakdown what each of these steps is.
1. Option Objective
The starting point when making any investment is your investment objective, and options trading is no different. What objective do you want to achieve with your option trade? Is it to speculate on a bullish or bearish view of the underlying asset? Or is it to hedge potential downside risk on a stock in which you have a significant position? Are you putting on the trade to earn premium income?
Your first step is to formulate what the objective of the trade is, because it forms the foundation for the subsequent steps.
The next step is to determine your risk-reward payoff, which is dependent on your risk tolerance or appetite for risk. If you are a conservative investor or trader, then aggressive strategies such as writing naked calls or buying a large amount of deep out of the money (OTM) options may not be suited to you. Every option strategy has a well-defined risk and reward profile, so make sure you understand it thoroughly.
3. Check the Volatility
Implied volatility is the most important determinant of an option’s price, so get a good read on the level of implied volatility for the options you are considering. Compare the level of implied volatility with the stock’s historical volatility and the level of volatility in the broad market, since this will be a key factor in identifying your option trade/strategy.
Implied volatility lets you know whether other traders are expecting the stock to move a lot or not. High implied volatility will push up premiums, making writing an option more attractive, assuming the trader thinks volatility will not keep increasing (which could increase the chance of the option being exercised). Low implied volatility means cheaper option premiums, which is good for buying options if a trader expects the underlying stock will move enough to put the option in (further in) in the money (ITM).
4. Identify Events
Events can be classified into two broad categories: market-wide and stock-specific. Market-wide events are those that impact the broad markets, such as Federal Reserve announcements and economic data releases. Stock-specific events are things like earnings reports, product launches, and spinoffs.
An event can have a significant effect 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. So do you want to capitalize on the surge in volatility before a key event, or would you rather wait on the sidelines until things settle down? Identifying events that may impact the underlying asset can help you decide on the appropriate expiration for your option trade.
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5. Devise a Strategy
Based on the analysis conducted in the previous steps, you now know your investment objective, desired risk-reward payoff, level of implied and historical volatility, and key events that may affect the underlying stock. This makes it much easier to identify a specific option strategy. Let’s say you are a conservative investor with a sizable stock portfolio and want to earn premium income before companies commence reporting their quarterly earnings in a couple of months. You may, therefore, opt for a covered call strategy, which involves writing calls on some or all of the stocks in your portfolio. As another example, if you are an aggressive investor who likes long shots and is convinced that the markets are headed for a big decline within six months, you may decide to buy OTM puts on major stock indices.
6. Establish Parameters
Now that you have identified the specific option strategy you want to implement, all that remains is to establish option parameters like expiration, strike price, and option delta. For example, you may want to buy a call with the longest possible expiration but at the lowest possible cost, in which case an OTM call may be suitable. Conversely, if you desire a call with a high delta, you may prefer an ITM option.
Examples Using these Steps
Here are two hypothetical examples where the six steps are used by different types of traders.
Say a conservative investor owns 1,000 shares of McDonald’s (MCD) and is concerned about the possibility of a 5%+ decline in the stock over the next few months. He doesn’t want to sell the stock but does want to protect himself against a possible decline.
- Objective: Hedge downside risk in current McDonald’s holding (1,000 shares); the stock (MCD) is trading at $161.48.
- Risk/Reward: Bateman does not mind a little risk as long as it is quantifiable, but is loath to take on unlimited risk.
- Volatility: Implied volatility on ITM put options (strike price of $165) is 17.38% for one-month puts and 16.4% for three-month puts. Market volatility, as measured by the CBOE Volatility Index (VIX), is 13.08%.
- Events: Bateman desires a hedge that extends past McDonald’s earnings report. Earnings come out in just over two months, which means Bateman will need to get options that extend about three months out.
- Strategy: Buy puts to hedge the risk of a decline in the underlying stock.
- Option Parameters: Three month puts $165 strike price puts are available for $7.15.
Since the investor wants to hedge his MCD position past earnings, he goes for the three-month $165 puts. The total cost of the put position to hedge 1,000 shares of MCD is $7,150 ($7.15 x 100 shares per contract x 10 contracts). This cost excludes commissions.
If the stock drops, the investor is hedged, as the gain on the option will offset the loss in the stock. If the stock stays flat and is trading unchanged at $161.48 very shortly before the puts expire, they would have an intrinsic value of $3.52 ($165 – $161.48), which means that they could recoup about $3,520 of the amount invested in the puts by selling them. If the stock price goes up above $165, the investor profits on his 1,000 shares but forfeits the $7,150 paid on the options
Now, assume an aggressive trader is bullish on the prospects for Bank of America (BAC). She has $1,000 to implement an options trading strategy.
- Objective: Buy speculative calls on Bank of America. The stock is trading at $30.55.
- Risk/Reward: The investor does not mind losing her entire investment of $1,000, but wants to get as many options as possible to maximize her potential profit.
- Volatility: Implied volatility on OTM call options (strike price of $32) is 16.9% for one-month calls and 20.04% for four-month calls. Market volatility as measured by the CBOE Volatility Index (VIX) is 13.08%.
- Events: None, the company just had earnings so it will be a few months before the next earnings announcement. Robin is not concerned with earnings right now. Rather, she believes the stock market will rise over the next few months and believes this stock will do especially well.
- Strategy: Buy OTM calls to speculate on a surge in the stock price.
- Option Parameters: Four-month $32 calls on BAC are available at $0.84, and four-month $33 calls are offered at $0.52.
Since the investor wants to purchase as many cheap calls as possible, she opts for the four-month $33 calls. Excluding commissions, she can buy 19 contracts (19 x $0.52 x 100 = $988).
The maximum gain is theoretically infinite. If a global banking conglomerate comes along and offers to acquire Bank of America for $40 in the next couple of months, the $33 calls would be worth at least $7 each, and their option position would be worth $13,300. The breakeven point on the trade is the $33 + $0.52, or $33.52. If the price isn’t above that at expiry, the investor will have lost the $1,000.
Note that the strike price of $33 is 8% higher than the stock’s current price. The investor has to be pretty confident that the price can move up by at least 8% in the next four months.
The Bottom Line
While the wide range of strike prices and expirations may make it challenging for an inexperienced investor to zero in on a specific option, the six steps outlined here follow a logical thought process that may help in selecting an option to trade. Define your objective, assess the risk/reward, look at volatility, consider events, plan out your strategy, and define your options parameters.
Disclosure: The author did not own any of the securities mentioned in this article at the time of publication.
Options: Picking the right expiration date
Volatility and Greeks can help make this decision, balancing time and cost.
- Fidelity Viewpoints
- – 07/05/2020
- The expiration date is the specific date and time an options contract expires.
- An options buyer chooses the expiration date based primarily on 2 factors: cost and the length of the contract.
- Volatility estimates, Greeks, and a probability calculator can help you make this decision.
Unlike stocks, exchange-traded funds (ETFs), or mutual funds, options have finite lives—ranging from a week (Weeklys 1 ) to as long as several years (LEAPs). The farther out the expiration date, the more time you have for the trade to be profitable, but the more expensive the option will be. Thus, figuring out the balance between price and time until the contract expires is a key to success when buying or selling options.
Unpacking the expiration date
When do options expire?
Let’s say that on January 1, you bought one April XYZ 50 call for a $3 premium (the cost of an option is known as the premium). This option would give you the right to buy 100 shares of XYZ stock (one contract typically covers 100 shares) at a strike price of $50 at any time before the expiration date in April—regardless of the current market price.
Suppose the underlying stock rose to $60 on March 1 and you decided to exercise your option, which was “in the money” because the strike price was less than the price of the underlying security. Your profit, before taxes and transaction costs, would be $700 ($60 stock price minus the $50 option strike price, less the $3 premium, times 100).
But was the April expiration date the best choice for your strategy? Let’s say that in January, you could also have bought a March XYZ 50 call option for a premium of $2, or a May XYZ 50 call option for a premium of $4. Here are the breakeven prices (the price the underlying stock must hit for the option to become profitable) for these 3 different hypothetical options:
- March XYZ 50 call with a $2 premium: $52 breakeven
- April XYZ 50 call with a $3 premium: $53 breakeven
- May XYZ 50 call with a $4 premium: $54 breakeven
The trade-off for the longer time until expiration is a higher cost and, consequently, a higher breakeven price.
How do you decide which expiration date is right for your strategy? Just as you need to make a price forecast for an underlying stock before picking an option’s strike price, so to do you need to make a forecast of how long it will likely take for your trade to become profitable before picking an option’s expiration date. As always, start with your outlook. Then, determine which specific option would be the most appropriate.
Here are 3 tools, among others, that can help you choose the right expiration date for your strategy:
Your assessment of volatility is one of the most important factors when selecting both your options strategy and the expiration date. Many options traders rely on implied volatility (IV) and historical volatility (HV) 3 options statistics to help them pick an expiration date.
Implied volatility, in particular, can be the X factor in options pricing. It can give you an idea of how expensive or inexpensive an option may be, relative to other expiration dates. Typically, the higher the IV, the more expensive the option.
For instance, let’s say the March XYZ 50 call has a 30-day IV of 20, the April XYZ 50 call an IV of 40, and the May XYZ 50 call an IV of 90. If XYZ was scheduled to report earnings in May, it might explain why that month’s IV is so much higher than the IV in previous months.
If you think the company is going to report very strong earnings that exceed the market’s expectations, and the stock is going to make a strong move higher as a result, it might be worth your while to purchase the more expensive May contract. By assessing each contract’s IV, you can weigh how much you are willing to pay for the length of the contract.
Furthermore, implied volatility tells you how cheap or expensive the premium is relative to past IV levels. A higher IV indicates a higher options premium. This may sound like a benefit to an option seller. However, you need to consider the trade-off, which is perhaps that a higher-than-normal IV may be due to an upcoming announcement or earnings release that is causing the market to expect a large price move. Thus, you need to weigh the cost against your expectation for the stock to move.
Volatility options statistics are available on Fidelity.com and Active Trader Pro ® .
A hypothetical call option’s days until expiration, theta, and option price.
Greeks are mathematical calculations designed to measure the impact of various factors—such as volatility and the time to expiration—on the price behavior of options. There are 2 Greeks in particular that can help you pick an optimal expiration date.
Delta, which ranges from –1 to +1, measures an option’s sensitivity to the underlying stock price. If the delta is 0.70 for a specific options contract, for instance, each $1 move by the underlying stock is anticipated to result in a $0.70 move in the option’s price. A delta of 0.70 also implies a 70% probability that the option will be in the money at expiration. Generally, the greater the probability that the option will be profitable at expiration, the more expensive the option will be. Alternatively, the lower the probability suggested by delta, the less expensive the option will likely be.
Theta quantifies how much value is lost on the option due to the passing of time, known as time decay. Theta is typically negative for purchased calls and puts, and positive for sold calls and puts. If XYZ were trading at $50, and a 50 strike call with 150 days until expiration had a premium of $5.30 and a theta of .018, you might anticipate that the option might lose about $0.018 per day until expiration, all else being equal.
The accompanying table reflects how theta tends to behave over time and its relationship to an option’s premium.
To find the delta or theta for an options contract, look at the options chain for a particular stock.
3. Probability calculator
If you want a more precise calculation of the probability that a particular expiration date will be in the money at various strike prices, you can use Fidelity’s Probability Calculator. Go to the options research page on Fidelity.com, select the Quotes and Tools tab, and then enter a ticker symbol or log in to Active Trader Pro.
The Probability Calculator enables you to adjust the stock price target, expiration date, and volatility parameters to determine the odds of the underlying stock or index reaching a certain price. The calculator also allows you to enter different expiration dates to determine the probability of a successful trade.
For example, you can see the probabilities of an underlying stock hitting different breakeven prices (e.g., $52, $53, $54) by March, April, and May. Using this information, you can assess how much you want to pay for the varying expiration dates.
Time to make the decision
Of course, there are other considerations when making an options trade. These include selecting the underlying stock to which the option corresponds, the liquidity of the option contract, the particular strategy you are considering, and the strike price, among others. And it’s critically important to understand all the risks and complexities involved with trading options.
The expiration date choice, in addition to these other decisions, can help you potentially improve the odds that your trade will end up in the money. When choosing the expiration date, it’s about balancing time and cost.
Next steps to consider
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Options Expiration | Everything You Need To Know
“Expiration” is a term that you will not hear a stock trader utter…why? Because when you own shares of stock, that ownership never expires (unless you choose to sell your shares of stock).
So why do options expire?
Unlike purchasing shares of stock, purchasing an option contract is generally used as a shorter-mid term investment. When you buy or sell an option contract (controlling 100 shares of stock), you must agree to an expiration date, as part of that contract.
As the buyer or seller of an option, you can choose which expiration cycle you would like to invest in. For most stock options, there are typically quarterly cycles, monthly cycles, and weekly cycles.
It is not vital to learn why expiration cycles occur in the weeks/months that they do (although we will touch on this a little bit in this post), but rather what is more important is understanding what expiration is and how to choose an expiration date because it becomes pivotal in determining whether or not a trade was a success or failure.
What Is An Expiration Cycle? A Brief History
Expiration cycles can be kind of confusing, so I’m going to do my best to break it down. 1973 is the year that the Chicago Board Options Exchange (CBOE) first started to allow equity trading. When they began, it was decided that when options are traded, there would be a total of four different months that each individual equity option could be traded during, each on a different cycle.
The CBOE in 1973
The typical increments for these options were 3 months, 6 months, 9 months, and 1 year. Typical cycles for an option would look something like this:
- January expiration, April expiration, July expiration, October expiration
- February expiration, May expiration, August expiration, November expiration
- March expiration, June expiration, September expiration, December expiration
Expiration Cycles Change – More Cycles!
Options gained popularity through the 70s and 80s as a way for investors to hedge their stock positions in the shorter term. As a result of this, in 1990 the CBOE made a change to the rules so that every stock option would have an expiration cycle in the nearest two months.
From then on, all equity options would have what was deemed a ‘front month’ (the closest month – generally the current month) and a ‘back month’ (the month proceeding the front month), which made the expiration cycles only slightly more complex.
Another development to expiration cycles spawning from the rising popularity of options in the 90s was the birth of a new type security, called LEAPS.
Long Term Equity Anticipation Security – Even More Cycles!
Long Term Equity Anticipation Security (LEAPS) were introduced as a way to make longer-term investments in stock options (things like indices did not have LEAPS until more recently).
So how long can an option contract actually be with LEAPS?
A LEAPS can expire up to 3 years from the current expiration cycle date, making the option as an instrument, a viable longer-term trading strategy for investors (I use ‘longer’ loosely because its very subjective and based on an investor’s trading style – i.e. for a day trader, 3 years would be an eternity, but for a buy and hold style trader, it’s short-term). LEAPS added on additional expiration cycles to underlyings, extending the investing calendar from 1 to 3 years.
Where does that leave us?
After LEAPS were introduced, expiration cycles got quite a bit more complex. Like previously mentioned, it’s not necessary for you to understand the ins and outs of why expiration cycles occur at the frequency/times they occur at. With trading softwares, it’s no longer necessary to memorize or understand why certain underlyings have certain expiration cycles and other don’t. What’s most important is understanding what expiration cycle choices you have to make.
If you do want to know more about how the cycles currently work after to the addition of front month/back month and LEAPs cycles, investopedia does a great job breaking it down here.
Why Is Options Expiration So Important?
In the most basic sense, expiration is important because it sets a timeframe for your trade. Whether or not a trade is going in the right direction and how much time left until that option expires define what profit or loss you will incur as an investor.
This chart shows how time decay (theta) impacts the price of an option.
How many days you have left until an option expires is called days to expiration (DTE). During the time between the placement of the trade and the expiration date, a variable called theta (time decay), will determine if your trade is profitable or not. As the amount of time until your option expires – theta decay – decreases, this is favorable to the seller of the option, and not the buyer.
One last reason expiration is so important is due to its relation with stock assignment.
One fear that keeps some traders from placing their first options trade is the fear of being assigned stock (especially if you have a smaller account with funds less than that of what 100 shares of a stock would cost). Don’t let this fear stop you from placing your first options trade. It’s not that scary, I promise!
If you sell an option (naked or as part of another strategy – i.e. Iron condor) and that option is in the money when the option expires, you will be assigned stock. If you buy an option, you will never automatically be assigned stock. As the buyer, you always have the right, but not the obligation, to purchase the stock via the option you invested in.
How To Choose An Expiration Date
Choosing an expiration can be difficult, so here are some things to keep in mind when choosing an expiration date.
When picking an expiration date, your trading style should guide what expiration you choose. For example, if you day trade, you will probably always use the nearest expiration cycle. A premium seller may want to go farther out and find an expiration cycles with about 25-50 days to expiration, while someone who does technical analysis may adjust their DTE according to what their charts are telling them (which can vary from underlying to underlying).
Are you a premium seller (someone who sells options to collect premium)? tastytrade has done a ton of research into the mechanics of selling premium. After countless studies, the research team has found that you stand the best chance of profiting when you sell options with 25-50 days to expiration.
As mentioned before, most stock options have weekly, monthly, and quarterly cycles. Something to keep in mind when choosing an expiration date is what cycle the option is in, as this can have an impact on how liquid the underlying is. Weekly cycles tend to be less liquid than monthly/quarterly, so you may have a little trouble getting out of a trade in a weekly expiration cycle. Always keep liquidity in mind when choosing an expiration.
That may leave you wondering: why would you choose to invest in the weekly expirations if those options are generally more illiquid than monthly expirations?
There are several answers to that question, but the most popular are that weekly expirations would fit better in your strategy (if you invest in options that are between 1-10 trading DTE, then weekly expirations would provide you more opportunities to invest) and weekly expiration cycles are commonly used for earnings trades.
Earnings are another important consideration when determining an expiration date (along with dividends for similar reason). Earnings are a binary event, meaning that one of two outcomes can occur. the price can go up or down after earnings are announced and many times, earnings cause large swings in an underlying’s price and there is a corresponding ‘crush’ in the options volatility.
If you put a position on and there are earnings before that position expires, beware of the possibility of the changes in price caused by the earnings announcement. The amount that an underlying may go up/down after an earnings announcement is called the expected move. What the expected move does is quantify the potential move using statistics and historical data, ultimately giving you a price range that the underlying is expected to stay between.
Understanding Expirations On tastyworks’ Trade Page
Understanding the concept of expiration is one thing, knowing how to decipher it within a trading platform can be a whole new ballgame (due to shorthand terminology).
Anytime you set up a trade on tastyworks, you will need to pick an expiration cycle. One of easiest ways to do this is using the expiration buttons on the trade page pictured below.
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