How to Pick Your Options Strategy
When it comes to trading stocks, traders can keep it simple. They can allow for a minimal amount of factors to be included and still do well. All that matters is direction. There are other factors, like the dividend, upcoming earnings and plenty of different chart formations to consider. But when it comes down to it, direction — whether up or down — is the only concern. Unfortunately, options trading is not the same.
In options, there are a number of factors. This can be good and bad, and it influences how we pick our options strategy.
How Options Trading Is Different
As we said with stock trading, traders really just need to decide whether the odds favor a move higher or a move lower. Because if they buy shares of ABC at $60 in mid-June and by mid-August (on expiration day), the stock is at $60.50, they still have a gain of 50 cents per share. A 50 cent move in the options world goes a lot farther than in the stock world, though.
For instance, if we were bought the August $60 call option for $1.00, we would need ABC stock to close at $61 by expiration just to break-even. Technically speaking, we chose the right direction, as the stock has rallied. But by needing ABC to rally $1 per share, the gain of just 50 cents per share leaves our position with a loss of 50%. Even if it rallied to $61, we’d have a gross gain of 0%.
See the difference? The stock-picker who buys shares outright has a 50 cent per share gain. On a 100-share trade, this is a $50 gain or nearly 1% when not factoring in commissions. For the options trader, even though they chose the right direction, they have a 50% loss before factoring in commissions.
I don’t know about you, but I’d rather have a ~1% gain than a 50% loss. But it doesn’t always work against the options trader.
In the same scenario, say the stock-picker buys ABC at $60 in mid-June. By mid-August, the stock has fallen to $59. The stock-picker currently has a loss of $1.00 per share, or a $100 loss on a 100-share trade. If our options trader instead sold the August $60 put for $2.00, they would be sitting on a 50% gain, or profits of $1.00 per share ($100). In order for the options trader to realize their maximum profit of $2.00 per share, they would need ABC to close at or above $60.
But because the stock fell to $59, those losses come right out the $2.00 premium the option trader collected. Even though it’s not maximum profit, as long as ABC stock closes above the $58 break-even price ($60 strike – $2.00 premium collected = $58 break-even price), our trader will show a profit.
In this case, the stock-picker winds up with a $1.00 per share loss, while our option trader — even though they picked the wrong direction — ends up with a $1.00 per share gain thanks to having the right strategy.
So About That Strategy — How Do I Pick the Right One?
Picking your strategy when it comes to options is no small task. But there are starting blocks. First, one must decide on direction. Do we believe a stock is going to trade higher, lower or roughly flat? Let’s say we think shares of ABC will trade higher. That eliminates a handful of option strategies, such as bearish and neutral plays. Instead, it leaves us with bull put spreads, naked put sales, bull call spreads, naked call buys and covered calls.
So beyond direction, we need to estimate how far we think this stock will rally. Will it grind higher, perhaps gaining 2% to 3% over the next two months? Are we looking for a larger move, say 7% to 10% over the next 60 to 90 days?
Let’s say we’re looking for the 2% to 3% move over two months. In that case, we may want to eliminate several of the strategies above. When looking for a larger move, we may want to consider selling naked puts or buying outright call options. Why? Because those strategies would allow us to generate a larger return.
Since we’re looking for a smaller move, we instead want to consider options strategies that will not only be profitable on smaller moves, but will make the most of the trader’s investment while also eliminating as much downside risk as possible.
Let’s use an example to drive home our point. So out of up, down or flat, we believe ABC will go up. Currently priced at $60, we believe the stock will only rally 2% to 3% over the next two months. Because of that, we will look to use either a covered call, a bull call spread or a bull put spread.
Before we can choose which one gives us the best return, we have two more factors to contemplate: Timing and volatility. If this is an overly volatile security, we may not want to put ourselves in a position where we reap little reward for large risks. We also need to determine how long this will take to play out.
If we think the move will happen in the next two months, we obviously don’t want to choose an option that expires in 30 days. Similarly, choosing one that expires in 120 or 180 days will likely be too long. Since options suffer from time decay — meaning the value of the option erodes as expiration becomes closer and closer — we want to chose carefully.
Volatility plays another huge role. If we’re looking for a 2% to 3% move in a Steady-Eddie company, we can expect lower volatility. Thus perhaps a strategy with higher risk may be warranted. Likewise, a high-volatility stock would likely warrant a lower risk strategy.
Let’s expand on our ABC example. At $60, we could deploy a bull put spread, a bull call spread or a covered call. However, if this is a high-volatility stock, we may have too much risk on the table for the covered call, given that we own the stock outright and are only selling an upside call against the position.
Likewise, selling the bull put spread for a small credit could leave us open to too much downside should this volatile ABC stock come crashing down. We don’t want to lose $4.50 trying to reap a $0.50 reward. These strategies could be equivalent to picking up pennies in front of a steamroller.
Instead though, the bull call spread could be our best bet for a high volatility stock. If ABC declines, we end up losing our small debit paid. Even though it’s a 100% loss, it’s likely to be vastly smaller than the covered call or bull put spread should ABC pull back significantly.
Conversely though, if ABC is a low volatility stock — which can be measured with its implied volatility — we may want to consider using strategies like the covered call and bull put spread.
Putting It All Together
In order to find the best options strategy, investors have to do more than decide on a direction. If we think a stock is going to bounce from support or breakout from current resistance, we need to take it a few steps farther.
We need to determine which direction ABC will go, how far it will rise or fall and when it will happen. We also need to determine the stock’s underlying volatility, plus factor in events like earnings, FDA announcements and/or investor meetings, along with dividend payments.
As we piece these factors together, we can narrow down the best strategies and choose the one with the best risk/reward profile. Just remember, it’s better to reap a smaller reward and actually get the reward, than it is to take on higher risk and suffer big losses.