How to Pick the Best Option Strategy
03/13/2012 6:00 am EST
Selecting the proper strategy ultimately determines a trader’s level of success, writes Dan Passarelli, citing eight factors option traders must evaluate when making this critical decision.
One of the more difficult problems for options traders has historically been the broad bid-ask spreads quoted for options. Experienced traders have routinely negotiated the bid-ask spreads downward with varying success when trading individual positions, but the non-economic price has been the significant effort and time required to achieve these negotiated results.
Beginning in January 2007, CBOE initiated a pilot program to reduce bid-ask spreads to as low as a penny. As of February 28 of this year, there were currently 360 in the series (including big names like Apple (AAPL), Microsoft (MSFT), and more) quoted in these penny increments. (CBOE maintains an Excel file of option series currently included within this “Penny Pilot” program here.)
Because option positions are frequently constructed with several individual legs, the impact of the ability to trade with tighter bid-ask spreads can have significant impact on the aggregate slippage of positions. Combined with the falling commission rates resulting from the increasingly intense competition amongst brokers specializing in options, significant trading efficiencies have resulted.
Do you know how many different types of options strategies there are? A lot; that’s how many! But that’s not really the important question. More importantly, do you know why there are so many different types of options strategies? Now we have something to discuss.
Different options strategies exist because each one serves a unique purpose for a unique market condition. For example, take bullish AAPL traders. Traders who are extremely bullish on AAPL get more bang for their buck buying out-of-the-money calls. Less-bullish AAPL traders may buy at- or in-the-money calls. Traders bullish just to a point may buy a limited risk/limited reward bull call spread. If implied volatility is high and the trader is bullish just to a point, the trader might sell a bull put spread, and so on.
The differences in options strategies, no matter how apparently subtle, help traders exploit something slightly different each time. Traders should consider all the nuances that affect the profitability (or potential loss) of an option position, and, in turn, structure a position that addresses each nuance.
Traders need to consider the following criteria:
- Directional bias
- Degree of bullishness or bearishness
- Time horizon
- Implied volatility
- Bid-ask spreads
Carefully selecting options strategies makes all the difference in a trader’s long-term success. Leaving money on the table with winners or taking losses that are larger than necessary can be unfortunate byproducts of selecting inappropriate options strategies. Be sure to spend time optimizing your options strategies over the next few weeks to build the habit.
By Dan Passarelli of MarketTaker.com