The Six Steps of Every Option Trade

05/31/2010 12:01 am EST

Focus: OPTIONS

Many times, I am asked the same question by different students: “Can you please show us the thinking process and the steps that you take when you are placing an option trade?” In this article, I will take the readers, once again, through the steps that I take when placing a trade on an optionable stock.

Frequent and faithful/loyal readers probably recall that in my previous articles, I have spelled out the exact steps that I personally go through prior to placing a trade. The example below was an actual trade that I took recently on EXPD.

Step One: Fundamental Analysis

During the first stage, fundamental analysis, I am concerned with several things, including to which index the stock belongs, what sector and industry, when is the earnings release day or dividend date, and is there a stock split coming? The answers for Expeditors International of Washington Inc. (EXPD) follow. It is a Nasdaq component. Its other index membership includes the S&P 500, as well as the Dow Jones Composite and Dow Transportation. Specifically, the EXPD is in the service sector and its industry is air delivery and freight services.

Its dividend date is set for May 27, 2010, which is a week after expiry. The dividend amount for EXPD is officially 0.20 per share. The company had reported its earnings on May 5, 2010, which was prior to my entry.

Step Two: Technical Analysis

Honestly, it was the technical analysis that first attracted me to this stock, even before checking the fundamentals. At the time, EXPD was forming a double top on its daily chart, which made me consider placing a trade on it. Next, I checked the daily chart of iShares Dow Jones Transportation (IYT), and after I noticed that they were both aligning in the same bearish way, it was then that I turned my attention to the EXPD fundamentals. Regardless of which step is taken first, FA or TA, they both must be done.

Step Three: Implied Volatility

Having done the technical analysis, we can turn our attention to the most crucial component of option trading: IV, or implied volatility. It is the IV that helps us to select the appropriate strategy. Anyone watching the market over the last several weeks knows that the volatility has just exploded through the roof. The EXPD was not an exception. Due to the bearish bias based on my technical analysis and the fact that the current IV was in the higher range of its historical volatility, I selected the short vertical as my option strategy. The bear call specifics are:

BTO (bought to open) May 45 (OTM) call @ $0.05 (money out)
STO (sold to open) May 42.50 (ATM) call @ $0.65 (money in)
Maximum profit ($0.65 – $0.05) is $0.60
Maximum loss ($45.00 – $42.50 = $2.50 – $0.60) is $1.90
Rate of return $0.60/$1.90 = 32%

On May 12, 2010, I entered into this position for the credit of 0.60 cents. At the time, there were only ten days left until expiry. The 12th was Wednesday, which means that out of those ten days, I was exposed to only three trading days in that week and five in the following one, which is basically eight trading days, while on the other two calendar days (Saturday and Sunday), I had no exposure to the market.

NEXT: Steps Four Thru Six Revealed

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Step Four: Proper Position Sizing

At this stage, I am really concerned with risk management. Without going into the exact calculation, just be aware of the fact that the position size must be proportionate to the account size. Do not supersize, but instead, during the learning stage, just go in with single lots (one contract per side/leg). Also, it is at this stage that I plan my exit(s). I am emphasizing the plurality of the exits, for in any situation, we must be aware of the fact that it could go in our favor or against us and we must have an exit plan for any scenario. (I will address this in greater detail in one of my future articles.)

Step Five: Entry and Active Monitoring

Trading the short verticals is not a type of trade that we simply place and forget about. It does involve monitoring, which isn't just monitoring the price action, but also monitoring the implied volatility. The reason why I am saying this is that I have sold a spread for a credit, and if the IV goes higher, then it actually hurts me because the short call premium goes higher, and I do not want to pay more to buy it back than what I sold it for. So monitor the IV just in case you have to close your spread.

Step Six: Exit and Learn

In this last stage, I wish to remind the readers about the need to buy back the obligation within the final expiry week. In fact, last week I wrote an entire article on that topic (see Always Buy Back Your Obligation). The easiest thing to do is simply place a buy back limit order for the short call that is GTC (good 'til cancelled) for a nickel. Whenever the time value comes out of that sold call to a nickel, then the order to exit will get filled and the obligation will disappear. Once that takes place, the money that was credited in our account becomes truly "ours" and the maintenance of $1.90 per contract is lifted.

By the way, the credit ($0.60) does get subtracted by the nickel that we have just paid to get out of our obligation, so technically speaking, we have not made the Max P (maximum profit) and our ROR (rate of return) wasn't 32% in ten days. To be exact, it was only ($0.55/$2.05) 27%, but I am sure most of us could live with a 27% return.

In conclusion, I have taken the readers once more through the steps that I take when placing a trade on an optionable stock. I do believe that every successful trader must be very methodical and systematic in his or her trading approach. Feel free to utilize these outlined steps or simply develop a set of your own.

Good luck and have green trading!

By Josip Causic, instructor, Online Trading Academy

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