Trader Q&A: How To Choose The Right Option

There are at least 4 factors to consider when choosing the right option

Dec 9, 2016 at 4:47 PM
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    Trading options can be tricky, to say the least, and picking the right option is crucial to maximizing your profit potential. Whether you're looking to buy or sell an option, there are certain things you must consider when determining which strike and series might be right. As such, I sat down with three pros -- Schaeffer's Senior Equity Analyst Joe Bell, CMT, Senior Options Strategist Tony Venosa, CMT, and Senior Trading Analyst Bryan Sapp -- to discuss their tricks of the trade. 

    Describe the "ideal" option to purchase.

    TV: Describing the "ideal" option to purchase is not an easy question to answer. It will depend mostly on the individual placing the trade, and the various factors to consider, which may not necessarily be considered "ideal" from one person to the next. Four of those factors are: time frame, outlook, risk tolerance, and volatility assumptions.

    The time frame of a trade is important because different traders can focus on one-minute charts, while another focuses on longer-term weekly/monthly charts for the same stock, and ultimately the two may have very different outlooks. This can lead to choosing the right expiration to match your particular outlook, which is essential to finding the right risk/reward profile. For example, if I think stock XYZ, currently at $50, can move $2 in the next five days, it isn't necessary to buy a three-month option. Similarly, if I think the same stock could move $10 in two months, I wouldn't buy a weekly option with a 10-day expiration period. So, a trader's time frame for the trade is essential to choosing the right expiration. 

    Risk tolerance will also play a role in deciding the ideal option to purchase. Assuming I allocate the same amount of capital, playing a deep in-the-money option where the option's value nearly moves in lock-step with the shares could be less of a risk, versus playing an out-of-the money option where a big move may be needed just to breakeven. This concept is referred to an option's delta, which is a measure of the sensitivity to the shares' price. If an option's delta is 90%, this means the option should move $0.90 for every $1 move in the shares. If an option's delta is 30%, this means the option's value will rise $0.30 for every $1 move in the shares, which obviously is less sensitive than the higher-delta option. 

    As far as volatility assumptions, if I assume a stock will be more volatile than what the options market is pricing, it makes sense to purchase options. But the options market can also over-estimate its outlook on volatility, making the options a less-than-ideal purchase.

    JB: Options are just tools, and there is no such thing as an "ideal" option to purchase or sell. As Tony said, there are varying factors that determine what options one should select at any given time. One analogy would be if someone asked you if a hammer or a saw was the ideal hardware tool. In that context, it would be difficult to answer. On one hand, when you need to put a nail in a piece of wood, a hammer is ideal, but when you need to cut a piece of wood in half, a saw is ideal. For options, there are over 20 different strategies you can use, and many different factors come into play to determine what the ideal option is at a certain time. The answers to two questions -- Where will this equity go in the future? and How long will it take to get there? -- will determine what option strategy you select. 

    In general, a trader may look to buy options when they believe premiums are cheap, relative to their volatility assumption, and sell options when they believe premiums are expensive, relative to their volatility assumption. However, as I said, there are varying option-buying and -selling strategies and each situation needs to be evaluated on a case-by-case basis to determine whether it is ideal for that trader and their outlook.

    Describe the "ideal" option to sell.

    TV: Discussing the "ideal" option to sell is similar to discussing the "ideal" option to buy, since traders need to consider the same factors, just in a different context. For example, selling out-of-the-money puts may be less of a risk than selling an in-the-money put, where the probability of the option finishing with value will be a lot higher on in-the-money options. The concept is to sell something with the expectation that it will not have value at expiration, suggesting the premium I collected on the sale is mine to keep. Another factor for selling options is attempting to choose shorter periods to expiration, which leaves you less exposed to unpredictable events that may cause heavy losses to your trade. It is also ideal to sell "expensive" options, which are options traders perceive as "overpriced."

    BS: Yes, the "ideal" selling option is one whose price is inflated -- we use Schaeffer's Volatility Index (SVI) to help us determine when option premiums are attractive or not --  and perhaps the stock has been in a very volatile period recently. The idea of volatility being "mean reverting" could signal that recent extreme volatility could lead to a dead period in the underlying, which is exactly what you want when selling premium.

    Expand on the concept of 'risk tolerance' when it comes to choosing the right option(s).

    BS: Risk is first when it comes to options trading. Given that options are so highly leveraged, a small move in the underlying can turn into a big loss quickly. As a result, I always choose the option that allows the most upside, but will also give me staying power in the trade. By "staying power", I mean it allows me to sit tight on a minor move against me. I generally won't take a trade unless the potential upside is at least a multiple of three times the theoretical risk. Assuming you have close to a 50% win rate, and follow your management rules, this will lead to profitable trading over time.

    JB: Risk tolerance is the degree of variability in investment returns that an investor is willing to withstand. Regardless of net profit potential, if the risk is too high, it will not be an option strategy with which one could maintain consistency. A trader may also panic and sell at the wrong time when they utilize a strategy that is too aggressive for them.

    Ability to take risk is a related -- but different -- factor. Regardless of an investor's risk tolerance, if they don't have an ability to assume the risk of a given option strategy, they should not invest in it. Sometimes a person's willingness to accept risk outweighs their ability to take risk, and it normally ends terribly. 

    Are there any hard-and-fast "always" and "never" situations when it comes to picking the right option(s)?

    BS: The only "always" I follow in trading is to always buy "cheap" options and sell "expensive" ones. This isn't always right, obviously, as expensive options can sometimes see outsized profits, but it's a general rule that we follow at Schaeffer's. It generally works out for the best.

    What tools or indicators do you use to choose options?

    TV:  I look at different periods of historical volatilities to get a general sense if the current implied volatility is being priced relatively high or low, such as our Schaeffer's Volatility Scorecard (SVS) metric. I also like to look at implied volatility versus its own annual range, which could also determine whether options are cheap or expensive, such as with the SVI. We also look at data that shows the various strike prices, volatilities, deltas, expirations, and so on, for the stock in question. 

    My favorite indicators are SVI, SVS, 10-day put/call ratios, and potential catalysts, such as conferences, macro data. With a catalyst in place, you give yourself the greatest potential for the stock/ETF to move in your favor in a short period of time. Obviously, even with a catalyst, you don't want to overpay for the options. This is where historical option pricing data and historical price moves are key to determining what's actually cheap and what isn't.

    JB: At Schaeffer's, we also use Trade-Alert, which offers tools to analyze option prices and volatility. In addition, we employ our Expectational Analysis methodology -- a combo of sentiment, technical, and fundamental analysis -- to determine our outlook for a stock. We offer different strategies and services that are appropriate for different people with different risk tolerances and abilities to take risk.  

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