Trading Options in 2022? Here’s One Tip To Live By

Do you have a plan for every options trade you make? If not, this post is a must-read. 

Trading options in 2022? You’re walking into an unprecedented market. An unprecedented Fed, with unprecedented quantitative easing, on top of historically high valuations. 

Don’t be scared. If you’re an options trader, you can make plenty of amazing trades off both the ups and downs by playing the ebb and flow of the underlying market.

But trading options takes more than just conviction, it takes a trade thesis. More than just “why you think $XYZ is going up”, a trade thesis is like your playbook. 

At the end of the day, you are your own quarterback. If Tom Brady is standing in the pocket with defenders barrelling down on him, it’s his job to process the situation and do everything in his power to avoid a sack. Trading options works the same way. 

If you’re getting pressed on a trade, you need to have a plan of action in place so you don’t get leveled in the heat of the moment.

So if you’re trading options in 2022, we recommend you follow this simple tip: 

Create a trade thesis before every options trade, and have the discipline to STICK TO IT!

How to craft your options trading thesis

Crafting a trade thesis takes a few steps. 

First, develop your reasoning. Your reasoning is simply why you’re running the play. For instance, maybe you notice that the stock $XYZ has been falling lately, and you’re looking for a place to get in with an upside option trade. Before jumping blindly into the trade, you need to ask yourself why you think it’s heading to the upside. To develop this, you need to do your research. 

Start taking in as much knowledge as possible about the underlying stock. Check the charts, get a good feel for the price action. Look at the volatility as it relates to itself historically, and the market. See what analysts are saying. Look at the indicators. Search for any recent unusual options activity. You want to find as many reasons as possible for the stock to go in your direction. 

For example, you notice that $XYZ has resisted falling below an established support at $100, which is near where it sits now. Looks good. You check the relative strength indicator — oversold. Looks good. But now the cherry on top: you see huge options purchases rolling in, indicating a big player thinks the bottom is in. Now we’re talking. We’ve built a deck of reasons why we think $XYZ is about to rip. Now it’s time to move on to the next step.

Decide how to execute the trade

So, now we know we want to make an upside bet. And we’ve found a few good reasons why. Let’s move on to the how.

To do that, we need to consider the many ways we can make an upside bet, from calls, to credit & debit spreads, and much more. Often, volatility is the most important factor in determining what options strategy to choose. You can look at volatility through several different lenses, like IV rank, IV percentile, and mean IV to determine how high the volatility of the underlying ranks against itself historically, or even look at the VIX to determine how volatile the overall market feels.

Volatility is a broad concept that we’re only scratching the surface of here, but if you want to learn more about volatility, check out How to Trade Volatility With Options. For the sake of brevity, we can boil it down to this rule of thumb: when volatility is low, it’s better to be an options buyer. When volatility is high, it’s better to be an options seller.

In our example, let’s say you notice that the volatility ranks very high relative to the past year. That means the options are going to be swollen with extrinsic value. In short? It’s an expensive option. You still want to make an upside bet, but you have to be careful not to overpay. So you utilize volatility to add an additional edge to your trade, by selling a bullish put credit spread. 

For the sake of our example, let’s say we’re selling the $100/$90 strike vertical put spread.

This is a bullish trade that involves selling a put (thereby collecting a credit from the buyer) and buying a cheaper put simultaneously to mitigate your risk to the downside. It’s a strategy we use all the time with our Smart Spreads service. And with that, you’ve developed the why, you’ve developed the how, and you’ve got one important piece left:

The “what if?”

The “what if?” addresses your plan of action. How will you manage the trade if it doesn’t go your way? This is something you always need to prepare for, because even the best traders make losing trades. The thing that separates the successful ones is that they know when to cut their losers, and when to stay the course. This is the phase of your trade thesis where you will make that decision.

If you recall our example, one of the reasons we became bullish on $XYZ was based on technical analysis. Our theoretical stock is trading near the $100 support, which has been a sturdy floor for $XYZ’s price action, with the stock almost always bouncing firmly whenever it reaches that price. The fact that it’s currently sitting near, but above that mark leads us to believe that we’re buying in at a good price, because we think $100 is the floor. But what if it isn’t?

We need to address the possibility that $XYZ loses the $100 support, and come up with a plan of action. Perhaps that means we set a stop-loss order at $99.50, with the knowledge that if it breaks below $100, it may go a lot lower. It can hurt to take a loss on a trade, but knowing when your trade thesis has been disproven can help you to stay disciplined, take smaller losses, and ultimately keep you alive in the options game. 

On the flip side, what if the stock skyrockets immediately? You made your options bet yesterday, it expires next month, and suddenly the option becomes so deep in-the-money that you have already amassed 95% of the maximum possible trade value. Remember, this is a spread. Are you going to wait an entire month to collect that last 5%, all while risking the 95% that your trade is currently worth? Or, will you take profits off the table? You should know the answer before entering the trade. This is the key to crafting the final piece of your trade thesis: knowing exactly when you will take profit, and exactly when you will cut losses. 

The bottom line

Let’s put a bow on it. You’ve learned the why, the how, and the what if. What’s left? Only the most important thing: DISCIPLINE! 

Discipline is the glue that holds your trade thesis together. The best plan in the world means nothing if you don’t have the discipline to follow it. That’s why it’s the number one thing that we teach at Market Rebellion. By arming yourself with the knowledge to make great trades, and the discipline to act on that knowledge in a controlled, methodical way, you can learn to dominate the options market. 

If you’re interested in applying these techniques to unusual options activity, then check out UOA Essential. It’s our most cost-effective, easy-to-understand service showing you how to trade unusual option order flow. And it can give you the tools you need to bolster your next trade thesis.