3 Tips for Selecting Option Candidates

04/04/2014 8:00 am EST

Focus: OPTIONS

Michael Thomsett

Founder, Thomsett Publishing Website

Before entering a trade, it is sensible to set two goals: the point where profits will be taken, and the bail-out point where losses will be cut, says Michael Thomsett of ThomsettOptions.com.

So many traders start out with a sensible plan, only to abandon it because of the way the markets move. This abandonment of a smart plan invariably leads to potentially small added gains but large added losses.

In entering a trade, it is sensible to set two goals: the point where profits will be taken, and the bail-out point where losses will be cut. If you buy a long option, you should know going in that 75% of options expire worthless, so setting goals to sell and close make sense.

For example, you buy a long option for 4 ($400) and set the following two goals: Sell when net value grows to 6 or above, representing a 50% profit; or sell when the value falls to 3 or below, a 25% loss. You know going in that time decay works against you, so you face the strong possibility of incurring losses from which recovery is unlikely. This means you have to select long options with some additional goals:

1. Pick options at the downside swing. This means you enter the long position on sessions when the market drops dramatically. Stocks tend to follow the broader market, so when an otherwise well-managed quality stock falls several points, you know it is part of the index drop and not a factor of the company. This may be the best time to buy a call for a fast swing trade turnaround.

2. Pick options at the upside swing. This suggestion does not contradict the one before. It is the opposite. Prices often rise just as irrationally as they fall. So when the index values jump sharply, stocks tend to go along for the ride; but you may see a retreat in the following two or three sessions. When the overall market prices rise quickly, but puts on the upside swing, anticipating a drop back to “normal” levels of trading.

3. Know your stock beforehand. Every stock exhibits particular trading tendencies and rhythms. Some tend to over-react to broader markets while others hardly react at all. This tendency, called beta, is a valuable technical factor in identifying how stock prices react to market movement. Stocks may tend to exaggerate news as well. So for example, a disappointing earnings report of only a penny per share may cause the stock price to plunge, only to get back most of its decline in the following session or two. Knowing how a stock tends to act and react helps pick options with better market intelligence.

By Michael Thomsett of ThomsettOptions.com

Related Articles on OPTIONS