Credit: Shutterstock photoToday, we're going to run through the four critical questions you should ask yourself before entering any kind of trade. While the urge to rush out and start trading as soon as you crack the seal on that new brokerage account, option players who hurry into a trading position without the benefit of a clear-cut strategy can usually be found wailing and gnashing their teeth in misery. Assuming you want something more fulfilling for yourself and your portfolio, let's explore a more reasoned approach to trading.
What are my expectations?
This question appears simple, but your answer requires extreme specificity -- otherwise, you might as well select which option you'd like to trade with the help of a blindfold and dartboard. Let's say that you've done some homework on Stock XYZ, and you've determined that the shares are poised to rally. Great! You expect the stock to move higher -- question answered, right?
Not so fast. How far do you expect the stock to move? Are you forecasting a 10% gain? A 20% jump? A 50% spike? Check out the charts, and determine how out of synch the equity's sentiment backdrop is with the technical performance. Looming resistance levels might prompt you to set your sights on a lower-strike call, while a whopping short-to-float ratio on a high-flying stock might encourage you to trade a further out-of-the-money option.
So, let's assume that you're looking for Stock XYZ to gain 15% from its current levels. That's an expectation, certainly, but it's still incomplete. How fast do you expect the move to happen? Are you looking for XYZ's 15% rally to occur in the space of a week, or do you predict that it will take a matter of weeks or months? Now that you've pinned down your target strike price, the answer to this next sub-question (if you will) can give you an idea as to which option series you should be looking at -- front-month? Back-month? LEAPS?
In other words, before you pull the trigger on a trade, you need to determine exactly how far you think the stock will move, in which direction, and how long it will take for this price change to occur.
What is the best trading tactic?
Again, this question seems deceptively simple. If you're bullish, you buy a call; if you're bearish, you buy a put... right? Well, yes and no. If it's that easy for you, then mazel tov ! However, there are different variations of bullish and bearish option strategies that can be employed, depending upon the specific technical setup (as well as your personal trading experience -- rookies are not encouraged to try their hand at an iron condor, for example, even if it seems wildly appropriate).
For example, let's return to our old friend XYZ. If you expect the stock to gain 15%, but you suspect its rally could continue even higher, you may well be best-suited to buy a call outright. However, what if you expect the stock to rally 15% before stopping short at long-term technical resistance?
In the latter scenario, you might be tempted to try your hand at a long call spread, also known as a debit spread . Essentially, you'll go ahead and buy your call to initiate a bullish position on the stock. However, you will also sell a call option at a higher strike, marking your expected technical ceiling for the stock. The sale of this higher-strike call will partially offset the cost of entering your purchased call -- plus, since you don't expect the shares to rise beyond the strike of the sold call, you won't have to worry that you're missing out on additional gains.
What is the risk/reward?
You've probably heard tell of the fabled risk/reward ratio. Fair warning: this question involves math. Please prepare your graphing calculators, protractors, and compasses accordingly. OK, just kidding -- the risk/reward metric is a fairly simple way to determine whether your potential reward on the trade merits the risk you'll be taking on .
In order to calculate your risk/reward ratio, you need to divide the amount you could potentially lose if the trade moves against you -- which is your risk -- by your expected profit -- a.k.a., the reward. So, let's say that you want to buy a 55-strike call option on Stock ABC when it's trading at $50. You expect the stock will be trading at $65 within the next six weeks, which is when you plan to take your profits and exit the trade. If the option is currently asked at $4.10, you'll spend $410 to purchase one call option controlling 100 shares.
Assume that ABC rallies as you expected, and the stock hits $65 just prior to your option's expiration. If you sell to close at this point, your option will be in the money by 10 points. In other words, you'll collect $1,000 by selling to close the option.
You risked $410, and you collected your target profit of $1,000. In the most literal sense, your risk/reward ratio on the trade is 0.41 -- for every one dollar you could possibly gain, you're willing to risk 41 cents. Of course, only you can decide what degree of risk fits within your comfort zone , and whether or not the potential reward justifies that risk.
What's my exit strategy?
If you're trading options, you have three basic ways to answer this question. You can exercise your option; you can buy/sell to close; or you can simply let the option expire worthless. (This last choice might sound like surrender, but it's actually a best-case scenario in some option-writing strategies.)
Finding your answer shouldn't be too hard. Do you want to acquire the underlying stock? If so, then you'll want to exercise your option once it's in the money. Would you prefer to collect a profit purely on the basis of price appreciation in your purchased option? In this case, buying or selling to close is your best bet. As for letting the option expire worthless ... it's not exactly something you can choose to do; usually, an option writer will simply cross his or her fingers and hope for the best.
Once you've determined your method of exit, you need to pinpoint when you'll make this move. If you're closing out your option without exercising, you might want to peg a target price for the underlying equity at which you'll exit the trade. Using the example above with Stock ABC, $65 would be your target price.
On the other hand, if you're exercising your option to buy or sell the underlying stock, you may choose to do so whenever your call or put goes in the money, at any time prior to expiration.
And what if your trade goes against you? Say that your purchased call is approaching expiration, and it's still five points out of the money. In this scenario, the cheapest and easiest option is usually to let the contract expire worthless. Otherwise, you'll rack up additional brokerage fees -- and for what? To close the trade out at a loss? Not worth it.
Conversely, if you're an option seller, you may be forced to buy to close your option if it's in the money (or dangerously close to the money) as expiration approaches. Otherwise, you run the risk of assignment -- unless assignment is your desired outcome, as is the case with some put-writing tactics.
So, not to sound too much like a flight attendant, but these are your exits. Determine your desired outcome for the trade, and choose accordingly.
Schaeffer's Investment Research Inc. offers real-time option trading services, as well as daily, weekly and monthly newsletters. Please click here to sign up for free newsletters. The SchaeffersResearch.com website provides financial news, education and commentary, plus stock screeners, filters and many other tools. Founder Bernie Schaeffer is the author of the groundbreaking book, The Option Advisor: Wealth-Building Techniques Using Equity & Index Options .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
