Pick the right options to trade in six steps

Low implied volatility means cheaper option premiums, which is good for buying options if a trader expects the underlying stock will move enough to increase the value of the options.. If

Pick the Right Options to Trade in Six Steps

• Examples Using these Steps

• The Bottom Line

Options can be used to implement a wide array of trading strategies, ranging from simple buy and sells to complex spreads with names like butterflies and condors In addition, options are available on a vast range of stocks,

currencies, commodities, exchange-traded funds, and futures contracts

There are often dozens of strike prices and expiration dates available for eachasset, which can pose a challenge to the option novice because the plethora

of choices available makes it sometimes 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 expiration dates to choose from

• Finding the right option to fit your trading strategy is therefore essential

to maximize success in the market

• There are six basic steps to evaluate and identify the right option,

beginning with an investment objective and culminating with a trade

• Define your objective, evaluate the risk/reward, consider volatility,

anticipate events, plan a strategy, and define options parameters

Finding the Right Option

We start with the assumption that you have already identified a financial asset

—such as a stock, commodity, or ETF—that you wish to trade using options You may have picked this underlying using a stock screener, by employing your own analysis, or by using third-party research Regardless of the method

of selection, once you have identified the underlying asset to trade, there 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 involves

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 withyour 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 income from selling option premium? For example, is the strategy part of a covered call against an existing stock

position or are you writing puts on a stock that you want to own? Using

options to generate income is a vastly different approach compared to buying options to speculate or to hedge

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 should

be dependent on your risk tolerance or appetite for risk If you are a

conservative investor or trader, then aggressive strategies such as writing puts

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 one of the most important determinants 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 increase the value of the options

Identifying events that may impact the underlying asset can help you decide

on the appropriate time frame and expiration date 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 asset Going through the four steps makes it much easier to identify a specific option strategy

For example, 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 writing 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 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 dates, strike prices, and option deltas For example, you may want to buy a call with the longest possible expiration but at the lowest possible cost, in which case an out-of-the-money call may be suitable Conversely, if you desire

a call with a high delta, you may prefer an in-the-money option

ITM vs OTM

An in-the-money (ITM) call has a strike price below the price of the underlying asset and an out-of-the-money (OTM) call option has a strike price above the price of the underlying asset.

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 fewmonths The investor does not 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: The investor 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: The investor wants a hedge that extends past McDonald’s

earnings report Earnings come out in just over two months, which means the options should extend about three months out

• Strategy: Buy puts to hedge the risk of a decline in the underlying

stock

• Option Parameters: Three-month $165-strike-price puts are

available for $7.15

Since the investor wants to hedge the stock position past earnings, they buy 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 put option will likely offset the loss in the stock If the stock stays flat and is

trading unchanged at $161.48 very shortly before the puts expire, the puts would have an intrinsic value of $3.52 ($165 - $161.48), which means that the investor could recoup about $3,520 of the amount invested in the puts by selling the puts to close the position

If the stock price goes up above $165, the investor profits on the increase in value of the 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) and 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 the entire investment

of $1,000, but wants to get as many options as possible to maximize 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 The investor is not concerned with earnings right now, but 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, they opt for the four-month $33 calls Excluding commissions, 19 contracts are bought or $0.52 each, for a cash outlay of $988 (19 x $0.52 x 100 = $988), plus commissions

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 the option position would be worth $13,300 The breakeven point on the trade is the $33 + $0.52, or $33.52

If the stock is above $33.01 at expiration, it is in-the-money, has value, and will

be subject to auto-exercise However, the calls can be closed at any time prior

to expiration through a sell-to-close transaction

Note that the strike price of $33 is 8% higher than the stock’s current price The investor must be confident that the price can move up by at least 8% in the next four months If the price isn't above the $33 strike price at expiry, the investor will have lost the $988

The Bottom Line

While the wide range of strike prices and expiration dates 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

Strike Price Selection Examples

Case 1: Buying a Call

Case 2: Buying a Put

Case 3: Writing a Covered Call

Picking the Wrong Strike Price

Strike Price Points to Consider

The Bottom Line

The strike price of an option is the price at which a put or call option can be exercised It is also known as the exercise price Picking the strike price is one of two key decisions (the other being time

to expiration) an investor or trader must make when selecting a specific option The strike price has

an enormous bearing on how your option trade will play out.

KEY TAKEAWAYS:

The strike price of an option is the price at which a put or call option can be exercised.

A relatively conservative investor might opt for a call option strike price at or below the stock price, while a trader with a high tolerance for risk may prefer a strike price above the stock price.

Similarly, a put option strike price at or above the stock price is safer than a strike price below the stock price.

Picking the wrong strike price may result in losses, and this risk increases when the strike price is set further out of the money.

Strike Price Considerations

Assume that you have identified the stock on which you want to make an options trade Your next step is to choose an options strategy, such as buying a call or writing a put Then, the two most important considerations in determining the strike price are your risk tolerance and your desired risk- reward payof.

Risk Tolerance

Let’s say you are considering buying a call option Your risk tolerance should determine whether you chose an in-the-money (ITM) call option, an at-the-money (ATM) call, or an out-of-the-money (OTM) call An ITM option has a higher sensitivity—also known as the option delta—to the price of the underlying stock If the stock price increases by a given amount, the ITM call would gain more than

an ATM or OTM call But if the stock price declines, the higher delta of the ITM option also means it would decrease more than an ATM or OTM call if the price of the underlying stock falls.

However, an ITM call has a higher initial value, so it is actually less risky OTM calls have the most risk, especially when they are near the expiration date If OTM calls are held through the expiration date, they expire worthless.

Risk-Reward Payof

Your desired risk-reward payof simply means the amount of capital you want to risk on the trade and your projected profit target An ITM call may be less risky than an OTM call, but it also costs more If

you only want to stake a small amount of capital on your call trade idea, the OTM call may be the best, pardon the pun, option.

An OTM call can have a much larger gain in percentage terms than an ITM call if the stock surges past the strike price, but it has a significantly smaller chance of success than an ITM call That means although you plunk down a smaller amount of capital to buy an OTM call, the odds you might lose the full amount of your investment are higher than with an ITM call.

With these considerations in mind, a relatively conservative investor might opt for an ITM or ATM call On the other hand, a trader with a high tolerance for risk may prefer an OTM call The examples

in the following section illustrate some of these concepts.

Strike Price Selection Examples

Let’s consider some basic option strategies on General Electric, which was once a core holding for a lot of North American investors GE's stock price collapsed by more than 85% during 17 months that started in October 2007, plunging to a 16-year low of $5.73 in March 2009 as the global credit crisis imperiled its GE Capital subsidiary The stock recovered steadily, gaining 33.5% in 2013 and closing at

Conservative Carla and Risky Rick.

Case 1: Buying a Call

Carla and Rick are bullish on GE and would like to buy the March call options.

Table 1: GE March 2014 Calls

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With GE trading at $27.20, Carla thinks it can trade up to $28 by March; in terms of downside risk, she thinks the stock could decline to $26 She, therefore, opts for the March $25 call (which is in-the- money) and pays $2.26 for it The $2.26 is referred to as the premium or the cost of the option As shown in Table 1, this call has an intrinsic value of $2.20 (i.e., the stock price of $27.20 less the strike price of $25) and the time value of $0.06 (i.e., the call price of $2.26 less intrinsic value of $2.20).

Rick, on the other hand, is more bullish than Carla He is looking for a better percentage payof, even

if it means losing the full amount invested in the trade should it not work out He, therefore, opts for the $28 call and pays $0.38 for it Since this is an OTM call, it only has time value and no intrinsic value.

The price of Carla's and Rick's calls, over a range of diferent prices for GE shares by option expiry in March, is shown in Table 2 Rick only invests $0.38 per call, and this is the most he can lose However, his trade is only profitable if GE trades above $28.38 ($28 strike price + $0.38 call price) before option expiration Conversely, Carla invests a much higher amount On the other hand, she can recoup part

of her investment even if the stock drifts down to $26 by option expiry Rick makes much higher profits than Carla on a percentage basis if GE trades up to $29 by option expiry However, Carla would make a small profit even if GE trades marginally higher—say to $28—by option expiry.

Table 2: Payofs for Carla’s and Rick’s calls

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Image by Sabrina Jiang © Investopedia 2020

Note the following:

Each option contract generally represents 100 shares So an option price of $0.38 would involve an outlay of $0.38 x 100 = $38 for one contract An option price of $2.26 requires an expenditure of

$226.

For a call option, the break-even price equals the strike price plus the cost of the option In Carla’s case, GE should trade to at least $27.26 before option expiry for her to break even For Rick, the break-even price is higher, at $28.38.

Note that commissions are not considered in these examples to keep things simple but should be taken into account when trading options.

Case 2: Buying a Put

Carla and Rick are now bearish on GE and would like to buy the March put options.

Table 3: GE March 2014 Puts

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Carla thinks GE could decline down to $26 by March but would like to salvage part of her investment

if GE goes up rather than down She, therefore, buys the $29 March put (which is ITM) and pays

$2.19 for it In Table 3, it has an intrinsic value of $1.80 (i.e., the strike price of $29 less the stock price of $27.20) and the time value of $0.39 (i.e., the put price of $2.19 less the intrinsic value of

$1.80).

Since Rick prefers to swing for the fences, he buys the $26 put for $0.40 Since this is an OTM put, it

is made up wholly of time value and no intrinsic value.

The price of Carla’s and Rick’s puts over a range of diferent prices for GE shares by option expiry in March is shown in Table 4.

Table 4: Payofs for Carla’s and Rick’s Puts

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Image by Sabrina Jiang © Investopedia 2020

Note: For a put option, the break-even price equals the strike price minus the cost of the option In Carla’s case, GE should trade to $26.81 at most before option expiry for her to break even For Rick, the break-even price is lower, at $25.60.

Case 3: Writing a Covered Call

Carla and Rick both own GE shares and would like to write the March calls on the stock to earn premium income.

The strike price considerations here are a little diferent since investors have to choose between maximizing their premium income while minimizing the risk of the stock being “called” away

Therefore, let’s assume Carla writes the $27 calls, which fetched her a premium of $0.80 Rick writes the $28 calls, which give him a premium of $0.38.

Suppose GE closes at $26.50 at option expiry In this case, since the market price of the stock is lower than the strike prices for both Carla and Rick's calls, the stock would not be called So, they would retain the full amount of the premium.

But what if GE closes at $27.50 at option expiry? In that case, Carla’s GE shares would be called away

at the $27 strike price Writing the calls would have generated her net premium income of the amount initially received less the diference between the market price and strike price, or $0.30 (i.e.,

$0.80 less $0.50) Rick's calls would expire unexercised, enabling him to retain the full amount of his premium.

If GE closes at $28.50 when the options expire in March, Carla’s GE shares would be called away at the $27 strike price Since she has efectively sold her GE shares at $27, which is $1.50 less than the current market price of $28.50, her notional loss on the call writing trade equals $0.80 less $1.50, or -

$0.70.

Rick’s notional loss equals $0.38 less $0.50, or - $0.12.

Picking the Wrong Strike Price

If you are a call or a put buyer, choosing the wrong strike price may result in the loss of the full premium paid This risk increases when the strike price is set further out of the money In the case of

a call writer, the wrong strike price for the covered call may result in the underlying stock being called away Some investors prefer to write slightly OTM calls That gives them a higher return if the stock is called away, even though it means sacrificing some premium income.

For a put writer, the wrong strike price would result in the underlying stock being assigned at prices well above the current market price That may occur if the stock plunges abruptly, or if there is a sudden market sell-of, sending most share prices sharply lower.

Strike Price Points to Consider

The strike price is a vital component of making a profitable options play There are many things to consider as you calculate this price level.

Unfortunately, the odds of such stocks being called away may be quite high New options traders should also stay away from buying OTM puts or calls on stocks with very low implied volatility.

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