Options trading can be a powerful tool for investors seeking to manage risk, enhance returns, or capitalize on market movements. However, it’s essential to approach options trading with a well-thought-out strategy to minimize risks and maximize potential rewards. Before placing an options trade, there are three key questions you should ask yourself:
1. Why am I entering this trade?
It sounds simple, but you might be shocked at how many traders are entering their trade on a guess, a good feeling, or simply the fact that they like the stock. These are not good reasons to enter a trade. Likewise, there are several reasons to invest in a stock that surprisingly don’t make great reasons to trade the stock. Things like what the company’s P/E ratio is, or who their key executives are, or their brand recognition – these are great reasons to invest in a company for the long term, and simultaneously terrible reasons to make a timed trade. No matter what your reasoning is – the most important thing is that you have one.
Understanding the purpose behind your options trade is the first step towards a successful strategy. The following aren’t the only reasons you might enter a trade, but they’re two common examples of strategies you might use to hunt down a catalyst. Those two examples are technical analysis and event-based trading. If you’re going to trade based on those catalysts, you should evaluate the following aspects:
Technical Analysis or Event-Based Trade
- Technical Analysis: Are you basing your trade on technical analysis, such as chart patterns, support/resistance levels, or momentum indicators? If so, what specific technical factors support your trade? It’s crucial to have a clear technical thesis for your trade and to consider both entry and exit signals derived from technical analysis. You might consider reviewing past instances of the technical signal in the specific stock and asking yourself, “does this stock respect the instrument I’m measuring it with?” For instance, if you’re considering trading a 3 & 8 period moving average crossover, you’ll want to scan back in time to see if the stock has respected this strategy as a signal of the trend. If you’re drawing a trend line, you’ll want to go back in time and see if there are past instances of the same trend line cropping up.
- Event-Driven Strategy: Are you trading around a specific event, such as earnings reports, economic announcements, or product launches? Understanding how events can affect the underlying asset’s price and the timing of your trade is essential. That can include reviewing historical data to help guide you. For instance, if you’re considering an options trade in an earnings event, you might use Options.ai’s free earnings outlook (which is not affiliated with Market Rebellion in any way) to gauge how much a stock has moved during recent earnings events. You might also review things like the IV rank, which measures the current IV (and thus, the “priciness” of the option) against itself in history, and you might even compare the current expected earnings move (the price of the earnings-dated at-the-money straddle) against the past earnings move. Performing this type of analysis can help you avoid non-optimal trade set-ups and hunt down optimal ones.
In either case, having a well-defined entry and exit strategy is vital.
2. What’s my plan for getting into the trade?
The entry point for your options trade is a critical decision. Consider the following factors:
Best Point of Entry
- Technical Factors: If using technical analysis, what is the ideal entry point based on your analysis? It could be a breakout above a specific resistance level, a bounce off a key moving average, or any other technical signal. You might want to ask yourself, “is the pattern I’m trading complete?” Notably, it doesn’t have to be. Some traders will trade a nearly complete pattern with a partial position, and then add more to the position if the pattern completes. Others will not only wait for the pattern to be complete, but wait for a confirmation candle – a small price move that follows the completed pattern which indicates the chart is moving in the direction you thought it would.
- Volatility and Premium: Depending on market conditions, consider the implied volatility and premium of the options. High volatility can increase the cost of options, while low volatility may make options cheaper. As we discussed above, IV rank and IV percentile are key measurements you can use to gauge the IV on a per-stock basis. From a macro perspective, you can look at the VIX for a broad-market gauge of volatility.
Expiration and Strike Selection
- Expiration Date: Choose an appropriate expiration date based on your trade duration and market expectations. Short-term traders may opt for weekly or monthly expirations, while long-term investors might choose options with a longer time horizon. Notably, the right choice will always be matching your expiration to the timeframe laid out in your thesis. If you’re trading an earnings event, don’t go too far out – staying near to the date often allows you to pay less in premium – and simultaneously risk less too. That doesn’t necessarily mean you have to pick the expiration that ends nearest to the earnings, but you should keep in mind that these options will carry the lowest likely cost and have the greatest movement potential. Likewise, if you’re trading a long-term technical pattern, you’ll want to match up your expiration appropriately, giving yourself plenty of time for the move to pan out.
- Strike Price: Select the strike price that aligns with your outlook. If you’re bullish, you may choose a call option with a strike price slightly above the current market price. For bearish positions, put options with a strike price slightly below the market price are suitable. However, there’s more that goes into that decision too. Out of the money options are cheaper, but they are rife with theta decay. If you’re choosing a near-dated option, and expecting a small-to-medium sized move, you’ll likely be happy with a slightly in the money option. If you’re going for a massive, fast-paced move, you might opt to spend less on the highly reactive, gamma-laden OTM options. No matter what you pick, you’ll want to do your research from step 1 to determine where the stock is likely to move so that you don’t get stuck with a situation where you were right directionally, but not enough for the stock to reach your strike.
Remember, the choice of expiration and strike price should reflect your trading thesis and risk tolerance.
3. What’s my plan for getting out of the trade?
Exiting an options trade is just as important as entering one. Consider the following exit strategies:
Rolling an Option or Turning it into a Vertical Spread
- Rolling: Consider this: You’ve made money on your trade, and you think it could go further, but you’d like to take some risk off the table. You could consider rolling your option to another cheaper strike. For instance, if you had a $100 strike call option that you bought for $50 dollars, and now it’s worth $100, you could “roll” the option by selling it and simultaneously buying a $105 strike call option at the same expiration for $50 – allowing you to trade with “house money.”
- Vertical Spread: Like the example above, if a trade is going in your favor, and you want to take some money off the table while remaining exposed to it, you could opt to “leg in” to a vertical spread. In the same example above, where you’re holding a $100 strike call option for $100, you could opt to simply sell a $105 strike call option against it. You’ll pocket the cost of the $105 strike call option, and cap your gains at a maximum of $5.00 ($500) per spread – however, you’ll reduce your risk in the process.
Closing the Trade Entirely
- Profit Target: Determine a specific profit target based on your analysis. Don’t get greedy; take profits when your target is reached. You don’t have to stay in the trade in any form, either. There’s nothing wrong with closing and moving onto the next one.
- Stop-Loss: Establish a stop-loss level that defines the point at which you’ll exit the trade to limit potential losses. This is crucial for managing risk.
Understanding your exit strategy is essential for protecting your capital and locking in gains.
Recognizing When Your Thesis is Wrong
- Invalidation Signals: Define the signals or conditions that would invalidate your initial thesis. This could be a technical pattern breakdown, unexpected news, or earnings results that contradict your expectations. For instance, if you charted a cup and handle, and within the handle portion, the stock broke decisively below the channel, that would invalidate your thesis, and be a big flashing “danger” sign. Have a clear plan for exiting when your trade goes against your thesis.
- Adaptability: Be prepared to adapt to changing market conditions. If your original thesis is no longer valid, it’s better to exit the trade and reassess rather than holding onto losing positions.
Successful options trading requires careful planning and disciplined execution. Before placing any options trade, ask yourself the three questions above:
Why are you entering the trade?
What’s your plan for getting in?
What’s your exit strategy?
Having a clear and well-defined approach to these three aspects can significantly enhance your options trading success and help you manage risks effectively. Always remember that options trading carries risks, and it’s essential to only trade with capital you can afford to lose. Want more information about the many things you can do with options? Check out our brand new book below, “It’s NOT an Option,” which digs deep into the world of options, from start to finish.
