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.
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