Option Investor
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What criteria do you use for option selection\?

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I've been getting a lot of questions lately as to how I (Jeff Bailey) like to trade options, and what I look for. I preface this with my trading discipline for options. I like to buy in the money options. If I normally like to trade 500 shares of a stock, then I only buy 5 contracts. If I'm normally trading 1,000 shares of a stock then I'm buying 10 contracts. This is my starting point and I need my trading discipline in place before I can tell if the "trade" makes sense.

Is the premium paid worth my time?

Let's use round numbers and assume that we normally buy 1,000 shares. The stock is trading at $37.25 and my discipline calls for in the money, so I'm looking at the Jan(01)$35's (IPAG). From today's 01:30 update, let's say I think the stock can achieve $41 by the time this option expires and the sooner the better! I can emphatically say, if IP trades at $41 tomorrow, the (IPAG's) should trade no less than $6 (41-35=6). Now I know there will be some premium to the option, but I want to be as conservative as possible (I can live with the upside, but I don't like downside). I can easily figure out what the "premium" is in the options currently. Shares of IP are trading at $37.25 and I could buy the (IPAG's) here at $2.88. Therefore, I now know that the option is carrying a ($37.88-$37.25=$0.63) premium until the option expires. Now, I might say "yes" this option is worth my time so I'll continue. If my answer were "no" I might look at the February contract and begin once again.

Call Option Chain for International Paper

Is the "risk" worth the "reward"?

Anytime I trade an option I enter the trade with the ability to say, "if I lose all my money in the trade, I am able to experience this loss without severely damaging my account." If you can't say the above statement, then you should not be trading the option, or should lower your contract amount until the above statement becomes "true". Now let's move on to the stop we had outlined earlier today for a bullish trade. Once I enter a long position in the above option, I NEVER look at that option again. I now turn my entire attention to the chart of IP. Remember in my trading plan, I had a stopping point of $36.50 based on the technicals. If the STOCK trades at $36.50 I'm selling my 10 contracts and that is it. That's my plan and I'm sticking to it. If the stock hits my target of $41, I'm selling the option as expiration is just around the corner and I realize going in that a potential 100% gain is at risk. If the stock begins to have "trouble" with the 50-period MA near $40, then I'm profitable in the option and may become a seller.

International Paper Chart - 60-minute interval.

The 60-minute chart of IP still looks interesting for a bullish option play. MACD is beginning to round out, but still below the zero level. Any trades made with these types of technicals should be "low risk" plays that are close to support where longer-term trends are upward. We've reviewed the daily interval chart earlier today and identified two levels of support (see today's 01:30 EST Update). We have also looked at a 10-minute chart of IP to set up our bullish entry point.

Focus on some of the points made, not so much the trade

While I like a bullish option trade in shares of IP today, it's not for everyone. Focus on some of the disciplines and thought processes for evaluating and options trade. If there's something useful you can pull from this update, and then you can incorporate it into you trading. Ideally, IP will be trading at $41 in the next several sessions and we will have learned so many good things. If shares of IP are trading at $36.50 tomorrow, before they hit $41, then we will have learned how the discipline could help down the road. We at least know the risk/reward the trade offers ahead of time.

Don't forget MARKET/SECTOR/STOCK

Now that we've identified some of the principles of an options trade and how to look at things, don't forget to monitor the corresponding index and broader market technicals. What is "tough" about trading IP is that we feel it is a "leader" in the group, or a strong stock in the group. If this is true, this stock will lead an advance in the Dow Industrials (INDU) and Forrest/Paper Products Index (FPP.X). Index option traders might be able to use this to their advantage! If the above observation (that IP is a leader) index traders might be able to use the stock as an "alert" to a move beginning in the FPP.X.

Jeff Bailey
Staff Analyst
www.OptionInvestor.com

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