How does one go about finding the best options to buy? What parameters do you have to look at while finding the top options for you? Do you just find the most active options to bet on in the market? Let’s take a look.
Successful options trading requires you to have a talent for prediction. When buying an option, you’ll need to forecast whether the stock price will rise or fall, how much it will change, and what time frame it will change within.
This article is divided into three parts.
Part I – Whether to buy or sell options
Part II – How to pick stocks for options trading
Part III – How to select the right option
Part I – Whether to buy or sell options
Why do people buy options if option selling is more profitable?
This is among the most frequently asked question as most of the options expire worthless, hence option writers/sellers tend to make money more often, more consistently than the option buyers. There are mainly 3 reasons to buy options –
- Hedging/Insurance – Many institutional investors hedge their long positions through options so they don’t have to take the entire brunt in case of an inevitable price fall.
- Part of another spread – As a part of a strategy you may be required to buy and sell at the same time.
- Speculation – Many traders try to make a huge profit quickly by buying out of money options.
Part II – How to pick stocks for options trading
Finding best stocks for options trading
So now that you have decided to buy or sell options, it is important to find the best stocks for options trading.
In trying to find the right underlying stocks, options traders mostly focus on the below things:
Liquidity – Liquidity is very important when looking for stocks and options to trade as it allows you to be able to get in and out of trade more easily. The most liquid stocks are usually those with higher volumes, so you need to focus on finding and trading high volume stocks.
Identify Trends – You can utilize charts and other historical data where possible to access the trend and find the right underlying stocks to trade.
Monitor Implied Volatility – With higher volatility comes higher premiums which makes writing a call more attractive assuming the volatility will not continue to increase to the point of causing the option to be exercised. On the other hand, lower implied volatility means cheaper priced options which benefits the options buyer if a trader believes that the underlying stock will move enough to finish further in the money. Traders also compare a stock’s historical volatility with its implied volatility to get a broader picture of what to expect.
Additionally, it is generally recommended to check the IV Rank to determine if the current IV of a stock is high or low relative to it’s past.
You can use the implied volatility screener from MarketXLS to find the most volatile options.
Identify Upcoming Events – Monitoring a company’s official web site where you might find lots of useful information, including press releases, planned events, and company news can help you be prepared to capitalize on any surge in volatility.
Utilize Stock Screeners – You can use the MarketXLS stock screener to eliminate those stocks that don’t meet the necessary requirements.
Part III – How to select the right options
Trading Strategy
Before starting to look for the right options it is best to be clear about the trading objective. There are a couple of reasons why people trade-in options. One is to hedge risk. Another is to make gains by betting on movements in prices, or speculation. The strategy you adopt will depend on your objective.
You may want to check out the unusual options activity while formulating the strategy.
Now that you have identified the stock and have decided upon a trading strategy, it is time to find the best option.
Choosing the strike price when buying options
It is imperative to understand the dynamic between how deep in the money or how far out you buy options and the likelihood of success
Options traders generally consider the below points while selecting the strike price-
- Further in the money contracts are less risky as the effect of time decay and volatility is lesser.
- Further out of the money are riskier as the effect of time decay and volatility is more.
- As a day trader, the effect of time decay is less if holding the contract for 5-60 minutes
- Swing traders need to be more careful comparatively.
- Longer expiration contracts are less risky as the impact of time decay and volatility is lesser.
- Shorter expiration contracts are riskier as the impact of time decay and volatility is more.
- As you move closer to the expiration date the percentage loss due to time decay increases.
- More volatile options have more decay.
Budget
Depending on your account size and risk tolerances, some options may be too expensive for you to buy. Hence, it is necessary to keep the budget at the back of your mind while selecting options.
Volatility
As stated above, implied volatility is one of the most important factors while choosing the option.
You can keep a track of your options strategy with the help of Options Strategy template of MaketXLS. Click here to learn more.
Conclusion
While the wide range of stocks, strike prices, and expiration dates may make it challenging for an inexperienced investor to zero in on a specific option, the above-mentioned procedure may make it easier in selecting an option to trade.
Disclaimer
None of the content published on marketxls.com constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person.
The author is not offering any professional advice of any kind. The reader should consult a professional financial advisor to determine their suitability for any strategies discussed herein.
References
https://www.angelbroking.com/knowledge-center/futures-and-options/most-active-options
https://www.investopedia.com/articles/active-trading/111214/pick-right-options-trade-six-steps.asp
