4 Steps for Choosing the Right Option

04/27/2011 8:00 am EST

Focus: OPTIONS

Elizabeth Harrow

Financial Analyst, Schaeffer's Investment Research, Inc.

This four-step checklist is designed to help option traders ensure that they’re paying a fair price and avoiding the common (and costly) risk factors that commonly plague less-experienced traders.

As novices and veterans alike can attest, there's a lot more to options trading than just picking a bullish or bearish (or neutral) bias. You might think Apple (AAPL) is a bargain at current prices, with the shares recently rebounding from support in the $330 region, but are you July 360 call bullish or are you October 360 call bullish? With the former option priced much lower than the latter, it makes a big difference.

But how are you supposed to decide which option you should use to achieve ultimate trading satisfaction? Today, we're going to review some basic steps you can take to pinpoint the best option to match your trading expectations.

Check Out the Charts

So, let's say you've decided that you want to play a long call on stock XYZ, which is trading just a few points shy of $40. You expect the stock to rally during the next couple of months, but you're uncertain about the longer-term forecast.

As a result, you're looking at options that have approximately two months until expiration. Ideally, the stock will rally above the strike price during this time frame, and you plan to sell to close your option in order to collect profits.

Now, since you've zeroed in so precisely on your trading strategy, I have to assume that you've already assessed the technical setup for XYZ. But, before you select your specific option, do us both a favor: look at the charts again.

What are you looking for? In this particular example, you're trying to pinpoint any and all resistance levels that could throw a wrench in your call strategy. (If you were purchasing puts, you'd be looking for potentially troublesome support levels.) Look at trend lines, moving averages, round-number regions; basically, any area that has previously or could possibly act as a technical roadblock.

So, assuming that you've already examined the charts before you adopted your bullish stance on XYZ, why am I making you look again? I promise, I'm not a taskmaster! But there's completing a cursory review of a stock's charts, and then there's reviewing those same charts with a specific trading strategy and goal in mind. Trust me, there's a difference. 

Your second review (re-review, if you will) could very well result in you choosing a 42.50-strike call rather than a 45 call.

You should also take this opportunity to check out the stock's open interest configuration for the month that you're interested in trading. With XYZ at $37, you're seriously considering that June 42.50-strike call, however, if there are already 75,000 contracts in open interest at this strike, you're looking at a rather crowded trade. 

Plus, you're savvy enough to know that heavy accumulations of call open interest can act as options-related resistance—another red flag.

So what do you do if this analysis leaves you doubting your entire trading idea? You can either give up entirely, in which case I must remind you that no one likes a quitter. Alternatively, you can try to revamp your approach.

Consider whether a different strike, time frame, or strategy will suit your goals, and work from there.

Go Conservative or Go Aggressive…Just Don't Force It

Next, consider your own personality, risk tolerance, and trading expertise. Are you conservative or aggressive? 

More conservative players might want to consider in-the-money or at-the-money options, which carry less risk of expiring worthless than their out-of-the-money counterparts. Meanwhile, aggressive traders trying to capture big profits will most likely be drawn to out-of-the-money contracts.

Keep in mind that in-the-money options will be more expensive to buy because they carry intrinsic value as well as time value. Conversely, out-of-the-money options are relatively cheaper, because they have no intrinsic worth.

You shouldn't let price be the deciding factor, though. In fact, if you're a newbie, let me make the decision for you: Your trading style is conservative. Trust me, until you get comfortable with the mechanics of options trading, it's much less scary to play with higher-Delta (read: in-the-money) options.

Conservative traders can also buy themselves some peace of mind by gravitating toward longer-term options. Not necessarily LEAPS (long-term equity anticipation securities), but even an extra month or two can contribute to your peace of mind.

Additional time value will run you additional premium dollars, but again, there's a tradeoff for the increased cost: The stock has more time to move as you expected.

The key here is to do whatever makes you feel the most comfortable. Just because all the cool kids are trading out-of-the-money calls doesn't mean that you have to. 

If the prospect of aggressive option trading makes your stomach turn, be kind to your inner wimp and buy that in-the-money call.

NEXT: Don't Get Burned by the News or Volatility Surprises

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Check the Corporate Events Calendar

This is an easy one! Once you've determined the time frame for your trade, you'll want to make sure that you're aware of any upcoming events that could potentially affect your position. These include earnings reports, primarily, but you'll also want to look out for new product launches, conferences, updates on trial data, and the like. Usually, a company's official Web site will include a complete list of all planned events on the horizon. 

Obviously, any of these events can impact the price of the underlying equity, as well as your options.  If you're trying to trade around an upcoming event, you have my blessing. Simply make sure that the expiration date of your options jibes with the timing of the event, and you're good to go.

Of course, there's no shame in intentionally avoiding event-based trading. 

Even if you opt to play a relatively neutral, “hedge-y” strategy, such as a straddle or strangle, the increased cost of entering the trade can be a deterrent.
If you've got your heart set on the options trade, but you don't want the aftermath of the event to throw your returns out of whack, you might want to decide whether it's worthwhile to exit the position just prior to the event. (Hint: If the event occurs two months before your options expire, the answer is most likely "no.") If not, you might want to wait until after the event to trade.

In addition to the potential ramifications to the share price, it's critical to be aware of upcoming events because they can play havoc with implied volatility on the stock's options. Which brings me to my next point...

Compare Historical and Implied Volatilities

When traders know an earnings report—or something equally exciting—is on the horizon, they begin betting on major movement out of the underlying stock. This translates to rising implied volatility, which in turn results in increased premiums. In other words, you'll likely be paying more than usual to trade options on the stock directly prior to an event. (This is good news for option writers, by the way.)

Maybe you're willing to pay more for options if the stock moves in your direction. This may be true, but consider this: After the event, implied volatility will implode. 

If “implieds” were bid high enough, it's possible that your option could lose value in the wake of this implosion, even if the stock moves in the right direction. Sobering, isn't it?

With this in mind, there's an easy way to find out if you're paying too much for that option. 

Through the use of this handy tool on our site, you can compare the current implied volatility on a stock's options against the historical volatility of that stock. Simply make sure that you're comparing the appropriate time frames. 

For example, if you want to buy a call with two months until expiration, compare the implied volatility on that call against the equity's two-month historical volatility.

Basically, this comparison ensures that the stock's options are fairly priced. If XYZ's two-month historical volatility is 45%, and a call option with two months until expiration is pricing in implied volatility of 85%, I personally wouldn't buy that option with my worst enemy's investing capital. 

In short, make sure you're paying a fair price when you enter the trade, or you're essentially sacrificing your potential profit.

By Elizabeth Harrow, contributor, Schaeffer’s Trading Floor Blog

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