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Options trading can be tricky and expensive. After all, it is a market that runs on traders’ expectations of the future price of an underlying asset. In the stock market, you have the luxury of time, here you don’t. As an options trader, you not only have to predict the price movement but also the time when that price movement will occur. While that is not enough, you have a plethora of choices available in the options market. Here is a review of the best options trading strategy for your trading style.
The Complete Guide On How To Choose The Best Options Trading Strategy
The Many Options in Options Trading
If you are bullish, there is a call option. If you are bearish, there is a put option. Then there is an option for different types of assets like stocks, ETFs, commodities, currencies. Each options contract has a different strike price and a maturity. With so many options contracts, you can mix and match to make your options trading strategy. While devising a strategy, you also have to make sure that it is cost-efficient, and you don’t spend all your money on options premium. All these layers in an options contract make options trading trickier.
If you are a novice trader, start with these basic steps of choosing the right options contract. Once you get a hang of options trading, these steps will come naturally to you, and you can try complex options strategies like butterflies and condors.
Step 1: Start by Studying the Underlying
The first step in any strategy is to know what you are dealing with. In a baseball game, you study the opponent team, their players, the pitch and design a game plan accordingly. Because you need a well-crafted plan A and a plan B to increase your chances of winning. The factors that affect commodities like gold and oil may not affect tech stocks or index ETFs.
Hence, it is important to know your underlying asset, the macro, industry, and company-specific events that could affect its prices and in which direction. For instance, the post-pandemic economic recovery boosted oil demand and increased oil prices. This was a bullish estimate for oil prices, making the call option a good buy. The automotive sector is suffering from a chip supply shortage, pulling down auto stocks. This is a bearish estimate for auto stocks, making the put option a good buy.
But your estimate should also be time-bound. Hence, it is always preferred to have assets that have a high trading volume. This ensures easy liquidity. To determine what constitutes a high volume, look at the stock’s and its peers’ average trading volume. You can also look at the historical trading volume of the stock close to an event. For instance, Shopify stock has higher trading volumes in the first four months of the year. This has been the case in three of the last four years. But historical data doesn’t guarantee future momentum. It only helps you make a calculated guess.
Step 2: Check the Implied Volatility of the Underlying
The whole concept of derivatives trading is implied. What do you feel about an asset, and does the other party feel the opposite? Implied volatility (IV) is a measure that tells you what market forecasts would be the price volatility of the underlying asset. It doesn’t tell whether the price will swing upwards or downwards. IV is generally high in a bearish market and low during a bullish market. This measure helps IV determine the option premium.
Look at IV as a risk factor in insurance. If you are insuring a house in an area prone to hurricanes, you can charge a higher premium as the risk is high. Similarly, if IV is high, you can get a higher option premium. For instance, during the BlackBerry short-selling event, options writers earned significant premiums as the IV was high.
You can look at the historical data of the resistance and support levels to determine your strike price. Then you can look at IV to approximately know the future value of the underlying asset.
Step 3: Be clear on your Trading Objective and Devise your Strategy accordingly
Now that you know your asset and have made your forecast about its future price momentum, it is time to determine the objective behind options trading. People come to the options market to hedge risk, speculate, and earn premiums. For instance, farmers hedge their produce against a dip in price by buying a covered put option that gives them the right to sell the underlying at a predetermined price.
Then there are speculators who are in the options market because they feel the price will go up or down. Here they square up their position by mixing put and call options. They might do a long short where they buy stocks they are bullish on and short stocks they are bearish on. Or they might also go for short selling as Redditors did with Gamestop and AMC.
The options market can also give you regular income through options premiums. There are many options strategies for the same, and one of the most famous ones is the wheels options trading.
Step 4: Determine your Risk-reward Payoff and Choose the Option
Lastly, you have to determine your risk-reward payoff. Whether the premium you are paying for the options is worth it. Every options strategy has a well-defined risk and reward profile. You can either lose a significant amount or cap your losses to the options premium paid.
For instance, you buy a put ($10 strike price x 100 shares) for a premium of $100, and the stock price goes up. You need not exercise the option, and you cap your loss at $100. But if the stock price surges to $13, you can exercise the option and get a profit of $200 ($300 profit – $100 premium). This is a case for conservative investors. But if you are an aggressive investor, you sell the put and take the risk. Here you have the obligation to buy the stocks if the buyer exercises the option. As in the above case, the seller had to bear a $200 loss.
The above four steps can help you make the right choice in a systematic manner. Any slacking off on the research part can lead to heavy losses, and at the same time, no strategy guarantees success. You can either make windfall gains and losses or cap your risks. If you know what you want, options trading is your playfield. There is no room for doubt.