This the second part of a series looking at understanding and trading options. The first post in this series looked defined key option terminology and ideas, while here I go into some basic trading strategies and patterns to improve your odds when trading options. You can see some of the concepts applied in recent trades.
I also want to reiterate that option trading done prudently is not speculation or gambling as some suggest. If you take the time to research and understand the upside and downside of the trade, then option trading is just another form of investing (or risk mitigation if used with existing stocks). Sure it is more risky, but then the potential returns are much higher and in a volatile or uncertain market (like we have now) it is the best way to make some money in the short term. Here’s some general trading strategies and signals to be aware of (continued from the previous post):
Buy an option before planned events that could affect the market, economy or stock. Examples of market moving news:
– Company is about to report their quarterly earnings
– Government is about to release relevant statistics (unemployment report, housing starts, etc.)
– Major elections are coming up (for president, senate seats, etc.)
– Hurricane season
– Rumors (takeover rumors, scandals, etc.).
- The Expiration Date is the month in which the option expires. All options expire on the third Friday of the month unless that Friday is a holiday, then the options expire on Thursday. Be mindful of this date when trading options because unusual and heightened activity can occur around the expiry date as traders look to close/open positions.
- After a number of down days in the market, consider buying 2 to 3 month forward index call options to benefit from the expected pop. I followed this strategy with QQQQ trade and in most cases it works out quite well. Markets are cyclical and what goes down must come up at some point. The reverse strategy can be applied for multiple up days in which you buy put options to benefit from the subsequent fall.
- It is probably best to buy options that have a term of at least three months and are no more than 10 to 20% “out of the money”. Example: Stock price = $100, Strike price = $120, therefore the option’s strike price is 20% “out of the money”.
I recommend selling an option (or closing the position) if the value doubles, or if it increases in value by 50% in one day. Chances are, if it increased in value by 50% in one day, it will “give back” some of the gains the next day. Keep in mind that although a stock can move up for three straight days, the option will move up fast on the first day in anticipation of continued upward movement, but the option will not have as dramatic of movements on days two and three.
In general, buy call options near the end of the trading day (3:58pm EST). And most importantly, on a DOWN day in the market (the buy low, sell high principle still applies).
- In general, buy put options near the end of the trading day (3:58pm EST). And most importantly, on an UP day in the market.
In general, sell a call option at the opening of the trading day (9:31am EST), if the market is due to rise – significantly. (e.g. The Dow futures are showing an open of 100 + points)
In general, sell a put option at the opening of the trading day (9:31am EST), if the market is due to fall – hard.
Never hold an option for more than 50% of its term. If the expected movement has not happened after 50% of the time has expired, it likely will not happen or will not be significant enough to substantially affect the option price.
Don’t buy options less than $0.10c. There is a reason why it’s so cheap and buying such cheap options is pure speculation.
- Be careful of the late summer. The volume dries up and sometimes the markets go static. More “players” mean more people love (or hate) the stock – gives you volatility.
- Because markets and stocks tend to fall faster than they rise, you can make quick money and a greater amount with puts. You can also lose money faster with puts when markets rise.
But, because markets trend upwards and most people are positive about the future, you are betting “against the tide” when you buy puts.
Option trading has two main costs. A base brokerage fee and a cost per contract. For example, you could pay $10 for the brokerage fee and $0.75c per contract traded. So a 10 contract trade will cost you $17.50. You pay this when buying and selling so the trading costs can add up quickly. For this purpose pick the lowest price broker for both cost components. Both low cost brokers who charge less than $5 for brokerage and less than $0.50 per contract. Much cheaper and as good as the bigger brokers.
The two key metrics to keep an eye on when trading options are the trading volume and open interest. Investopedia provides a good definitions and usage of these metrics, which I have summarized here. Trading volume gives you insight into the strength of the current market direction for the option’s underlying stock. The volume, or market breadth, is measured in shares and tells you how meaningful the price movement in the market is. Keep in mind that trading volume is relative and needs to be compared to the average daily volume of the stock in question. A large percentage change in price accompanied by larger than normal volume is a solid indication of market strength in the direction of the change. But large percentage increases in price accompanied by small trading volumes are less likely to indicate a market direction. In fact, they may indicate that a reversal is likely in the near term.
Open interest tells you the total number of option contracts that are currently open – in other words, contracts that have been traded but not yet liquidated by either an offsetting trade or an exercise or assignment. While it may be less important than the option’s price, or even current volume, open interest provides useful information regarding the liquidity of an option. If there is no open interest for an option, there is no market for that option. When options have large open interest, it means they have a large number of buyers and sellers, and an active market will increase the odds of getting option orders filled at good prices. So, all other things being equal, the bigger the open interest, the easier it will be to trade that option at a reasonable spread between the bid and ask.
NEVER, NEVER buy a call option on a big up day and NEVER, NEVER buy a put option on a big down day. You will pay a premium and even if you are right, there is no buffer built-in for a safety net.
This overview of options and associated trading tips should get you started on the road to trading options, but it is the very tip of the iceberg. Once you are comfortable trading stocks, consider options because they open up a whole new world of investing possibilities. I will look at some more advanced option trading strategies (like covered calls, straddles, butterfly spreads etc) in future posts.