When choosing an option strategy, there are a lot of things that we want to consider. Whether it’s directional assumption, liquidity or avoiding certain events, there is a checklist of things we look at before entering a trade.
First and foremost, we need to assess our directional assumption. Are we bullish (want the stock price to rise) or bearish (want the stock price to fall)? After we decide this, we can hone in on some strategies.
Liquidity is king. If we can’t get out of a trade, regardless of whether it’s a winner or loser, we put ourselves at the mercy of the market. We always trade the most liquid underlyings so that we don’t have this problem. Open Interest, Volume, and the bid/ask spread are the key liquidity factors we focus on.
Open Interest is the amount of open contracts there are in the market. Open interest increases by one when a new buyer and new seller create a contract. It decreases by one when that contract is closed.
Volume is the number of contracts that trade hands that day. This number can only go up.
The bid/ask spread is a good way to determine whether an option or stock is liquid or not. It is the difference between the natural price of where I can sell an option or stock (bid), and the natural price of where I can buy an option or stock (ask). If the spread is narrow, it indicates there is agreement on a fair price with a lot of market participants. This is what we’re looking for. If the spread is wide, it indicates there is not an agreement on a price, and there are usually fewer market participants. This is where we can get stuck in trades, or forced to get out at an unfair price.
Implied Volatility is another important consideration. IV Rank & IV Percentile are two metrics that we use to put context around implied volatility. It doesn’t matter which ranking system you use, but it’s important to be consistent in which one you prefer.
If implied volatility is high, we like to deploy premium selling strategies such as strangles, straddles, iron condors, etc.
If implied volatility is low, we like to deploy premium buying strategies such as vertical debit spreads, calendar spreads, diagonal spreads, etc.
Events such as earnings and dividends are important to keep in mind when deploying strategies. If we don’t want to place an earnings strategy, we should ensure that the underlying’s earnings announcement doesn’t fall within our trade’s expiration. Dividend risk applies to ITM short calls, so it’s important to keep track of the ex-dividend date as well so we aren’t left with short shares that we don’t want.
While implied volatility & directional assumption play a role in strategy selection, there are also a few other factors we like to consider. Do we prefer credit or debit strategies? Credit strategies may have fluctuating buying power reduction levels, where debit strategies do not. We also want to consider trade size relative to our portfolio. We like to stay small, and keep our individual trade buying power less than 5% of our net liquidating value. Finally, we analyze our risk profile. Am I ok with selling a naked call, or would I feel better if I sold a call spread instead? These are the questions we ask ourselves when selecting a strategy.
Another aspect of the trade to keep in mind is return on capital. Am I putting myself in a position where I can realize a fair profit for the amount of risk I’m taking? Or is this trade not even going to clear commissions if it’s fully profitable? When selecting a trade, we focus on return on capital relative to risk, as well as commissions. Generally speaking, a higher return on capital results in a lower probability of profit. A lower return on capital results in a higher probability of profit. Finding the sweet spot has everything to do with your personal risk profile.
Market Data provided by CME Group & powered by dxFeed Technology. Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”). tastytrade is a trademark/servicemark owned by tastytrade.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.
Small Exchange, Inc. is a Designated Contract Market registered with the U.S. Commodity Futures Trading Commission. The information on this site should be considered general information and not in any case as a recommendation or advice concerning investment decisions. The reader itself is responsible for the risks associated with an investment decision based on the information stated in this material in light of his or her specific circumstances. The information on this website is for informational purposes only, and does not contend to address the financial objectives, situation, or specific needs of any individual investor. Trading in derivatives and other financial instruments involves risk, please read the Risk Disclosure Statement for Futures and Options. tastytrade is an investor in Small Exchange, Inc.