Picking the Best Instrument to Trade

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Picking the Best Instrument to Trade

Some instruments move together, while others move in opposite directions and some share no relationship whatsoever. Such relationships can play a key role in determining which trades you make and why. While you may not be aware of it, when you get a trade signal in one instrument, signals are also likely triggering in other markets which may present a greater chance of a success. If you trade forex, or forex options this is often the case. With so many pairs, most binary trades you make will have at least one of two substitutes that you could trade instead. By understanding relative strength and weakness you’ll be able to pick the best market to take your long/call or short/put trades respectively. Compare any instrument to another to see which is the better instrument to trade.

Correlation and Comparing Markets

Say you look at the USD/JPY price chart and see a potential trade, and also happen to notice one on the EUR/JPY chart as well. This is quite likely as these two forex pairs share a high correlation (at the time of this writing). A correlation is how closely the movement of one asset mimics another, with a high correlation of 90 to 100 meaning the markets move in a very similar fashion. A correlation of -90 to -100 means the markets move in the opposite direction to each other.

Based on my May 2, 2020 correlation data (updated regularly here: Forex Daily Stats) there are a number of forex pairs which have high correlations to each other.

On the shorter time frame, there are many strong correlations. Although, these short-term correlations are not very reliable, therefore the daily correlation provides a more accurate picture of which pairs are moving together and which are not.

Here are some of the strong correlations (90+) worth noting:

USD/CHF and USD/CAD at 90.9

Since these pairs are trading with a high correlation, one pair could be used a substitute for the other. For example, one may provide a slightly better opportunity than the other. If you see a trade in one, check the other as well. In the next section we’ll go over what to look for.

USD/JPY and EUR/JPY at 96.4

USD/JPY and GBP/JPY at 97.1

EUR/JPY and GBP/JPY at 94.3

The JPY is moving similarly against the USD, EUR and GBP. Therefore, if making a trade using a Yen (JPY) pair, look at the charts of other Yen pairs to see which is likely to provide you with the most successful trade based on which direction you want to go, long (call) or short (put).

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You’re checking your charts, looking for trades, and you see the following:

While you may not trade the daily time frame, and prefer shorter term trades, the massive uptrend grabs your attention and gets you thinking about taking a long position/buying calls in the USD/JPY.

But you now also know, based on the correlations, that the EUR/JPY and GBP/JPY are likely moving in a similar fashion. Now you have a choice. Which pair provides the higher probability for going long/buying calls?

Often picking the one which is showing relative strength is the best choice. Relative strength is simply the strongest of the possible choices, often determined by percentage increase, or the ability to continually generate higher highs and higher lows (while another of the choices may not be able to).

One way to easily compare the performance of assets is to use the Comparison setting on www.freestockcharts.com.

Overall the chart shows the EUR/JPY (purple) and USD/JPY (green) have been stronger than the GBP/JPY. But that may be changing as the GBP/JPY is approaching its recent highs, while the EUR/JPY and USD/JPY have fallen off their respective highs. If the GBP/JPY breaks to a new high before the other pairs do, it will be showing relative strength and therefore presents a relatively good trading opportunity compared to the other two on a short-time frame.

Overall though, since the USD/JPY and EUR/JPY have been stronger over the long term, if the weaker GBP/JPY breaks higher, it could be a good opportunity to go long the USD/JPY or EUR/JPY as the historical precedent here (which could change at any time) is that they will continue to outperform the GBP/JPY.

When you find a short or put trade you like, the same concepts apply except you’ll want to take the trade in the weakest of the choices.

Let’s use the same pairs, and decide which is weakest over a few day period.

Since the start of this week, the USD/JPY (green) has consistently underperformed the EUR/JPY and GBP/JPY showing that on this timeframe it is weaker. Notice also how the USD/JPY continually makes lower lows and lower highs, while the other two pairs haven’t (they’ve been stronger).

If you were looking take a short position in either the USD/JPY, EUR/JPY or GBP/JPY, based on this evidence the best choice would be the USD/JPY.

Relative strength is a tool to be used in conjunction with your trade strategies. You may get a signal in one pair, but if you know that pair is highly correlated to others, check those pairs as well as they may present a better opportunity. Ideally you want to always be buying (calls) in the strongest assets and shorting or buying puts in the weakest ones. Remember though, what is weak or strong one day, may not be the next. Don’t simply trust historical tendencies, but rather monitor them in real time by comparing the movement of one asset to another. This is a more advanced technique, but can pay big dividends as it may keep you on the right side of strong and weak markets.

Top Day Trading Instruments

Day trading involves buying and selling (or first short selling and then buying back) an instrument with an aim at making a quick profit. The holding duration may vary from a few seconds to a few hours but not exceed the span of a trading day. For example, a speculative trader may spot a technical uptrend in Microsoft Corporation stock (MSFT) at 10:15 a.m., take a long position and square it off in 45 minutes for a quick profit.

A carry-over of the position to another day does not qualify as day trading. By its nature, day trading requires quick and timely action by a trader, usually in higher values that cover the thin profit margins. Overall, small profits on large volumes give day traders an acceptable profit. Most day trading occurs on margin, allowing traders with limited capital to take large positions that equal many times their trading capital. The large volume also ensures lower transactional costs.

Multiple tradable assets are available in the global markets, including stocks, bonds, forex, commodities and various derivative instruments on those (like futures, options, or swaps). When it comes to short-term trading, a few assets tend to outperform the others.

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.

Key Takeaways

  • 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.

  1. Formulate your investment objective.
  2. Determine your risk-reward payoff.
  3. Check the volatility.
  4. Identify events.
  5. Devise a strategy.
  6. 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.

2. Risk/Reward

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.

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.

  1. Objective: Hedge downside risk in current McDonald’s holding (1,000 shares); the stock (MCD) is trading at $161.48.
  2. Risk/Reward: Bateman does not mind a little risk as long as it is quantifiable, but is loath to take on unlimited risk.
  3. 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%.
  4. 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.
  5. Strategy: Buy puts to hedge the risk of a decline in the underlying stock.
  6. 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.

  1. Objective: Buy speculative calls on Bank of America. The stock is trading at $30.55.
  2. 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.
  3. 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%.
  4. 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.
  5. Strategy: Buy OTM calls to speculate on a surge in the stock price.
  6. 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.

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