Options are available on a large number of financial instruments including stocks, currencies, commodities, exchange-traded funds. Although availability on a number of these instruments is an advantage for traders, it is always a challenge to find the best options to trade even for the novice trader.
Well, you may start by using a stock screener to pick the underlying asset. The other option is to carry out an analysis or use third-party research in order to identify the options that you should trade in. You can use the six steps below to make it easier to pick a specific option for trading.
- Option objective: Do you want to simply speculate on a bullish or bearish view of the underlying asset, hedge potential risks, or is the objective to just trade in order to earn premium income?
- Consider the risk/reward: The risk-reward payoff depends on appetite for risk or risk tolerance. The strategies to pursue depends on the type of trader: writing naked calls or buying a large amount of deep out of the money (OTM) options and other aggressive strategies are not suitable for a conservative trader, for instance.
- Volatility: When trying to identify the best options to trade, check the volatility history of the asset involved and compare with other assets in the market. While it can be difficult to determine the actual volatility, implied volatility can tell you whether other traders are expecting the stock to move a lot or not.
High implied volatility pushes up premiums and makes writing an option more attractive. This happens when assuming that the trader hopes the volatility will not continue to increase. Low implied volatility will push lower the premiums and this makes it attractive to buy the options if the expectation is that the underlying stock will move enough to put the option in.
- Events: Market-wide events such as Federal Reserve announcements and economic data releases will affect the broader markets while stock-specific events such as earnings reports, product launches, and spinoffs have effects restricted to the specific stock.
The key issue here is that events will affect implied volatility until they occur and a trader needs to decide whether they want to capitalize on the volatility surge before the event or wants to wait until the event occurrence when things settle down.
- Strategy: Doing all the above four things leaves you with a strategy that you would like to pursue. For instance, a covered call strategy (which involves writing calls) is most suitable for a conservative investor who wants to earn premium income before the companies commence reporting their quarterly earnings in a couple of months.
6. Parameters: Expiration, strike price, and option delta are some of the parameters you would like to establish. For instance, an OTM call is most suitable for those wanting longest possible expiration but at the lowest possible cost.