How to Choose Which Option is the Right Option, Every Single Time

Unsure which options contract is right for you? We're here to help

Jul 2, 2015 at 2:08 PM
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If you're ready to play a call or put option on a specific stock, we'll assume you've already done your due diligence on the charts. You've pinpointed any and all support or resistance levels that could throw a wrench in your strategy -- including trendlines, moving averages, round numbers, previous lows, half-highs, and so on.

But with so many different strike prices and expiration series available, there's more to choosing the right option than simply going through your technical paces. Here are three simple steps to fine-tune your approach.

Know your trading style. Conservative players might prefer in-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 likely be drawn to out-of-the-money contracts. Conservative types may also prefer intermediate- or long-term options, as opposed to weekly or front-month. Additional time value translates into higher premiums, but the stock will have more time to move as expected.

Check the corporate calendar. Make sure you're aware of any upcoming events that could potentially affect your trade, such as earnings reports, product launches, conferences, FDA rulings, and the like. Usually, a company's official website will include a list of all planned events on the horizon. If your intent is to trade the expected outcome of a potential catalyst, it makes sense to select the nearest expiration date to avoid paying for time you don't necessarily need. On the other hand, if you'd prefer a buffer against potential event-related risk, set your sights on longer-term options.

Compare historical and implied volatilities. Implied volatility (IV) is a significant component of an option's price -- so when IV is high, so are premiums. The more you pay for an option upfront, the greater the stock's move must be for you to profit. As a result, it benefits option buyers to avoid options with relatively high IV. To determine whether or not you're overpaying, compare the implied volatility on an option against the stock's historical volatility for a comparable time frame. If IV is considerably higher than historical, that's a red flag for any prospective option buyer.

 

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