Recent Options 101 articles advocated familiarity with your strategy on your preferred vehicle.
But what if you're new to trading and have no preferred strategy or vehicle? What if you've been battling your former favorite trade and have decided you can't wrestle it into submission? Perhaps your new job allows you no breaks during which you monitor your trade and make adjustments other than once, at lunchtime. Maybe the birth of a new baby doesn't allow you to sit at the computer all day, and, even if you could, you'd rather gaze into her face.
How do you find a favorite trade or underlying? First, I would warn that this current market environment is not one in which you should throw a lot of real money into the endeavor. It's a great learning environment, as long as you're not losing a lot of money to learn what you'll be taught. You have to have confidence in your trade and in your abilities before you can trade well. Otherwise, you'll make panicked decisions. Even experienced traders were scrambling on Monday and Tuesday, July 23-24, for example.
A first decision lies in the vehicle you'll use. Tax considerations come into play with this decision. Some vehicles such as the cash-settled indices and futures get preferential tax treatments. All such treatments are under scrutiny these days, so I don't want to be too specific as treatments could change. For now, some of the profits in futures and options on those cash-settled indices are treated as long-term profits for tax reasons, no matter how long or short the trade. Do your research. Some decisions about the right trade might be different depending on whether you're trading in a cash account or an IRA.
If you're leaning toward an individual stock or an ETF that has dividends, be sure you determine the ex-dividend date before you engage in an options trade, particularly one that involves selling ITM calls. The ex-dividend date can come and go, and you can find that those calls have been assigned, and you owe someone dividends to boot! If you're making these decisions in the midst of earnings season, do consider the impact that earnings will have on any options trade. Implied volatilities tend to rise into the earnings release and then collapse unless the after-earnings move is bigger than anticipated. That's the reason that Option Investor has long advised that options traders not carry their trades over earnings. Traders experienced with the way options behave over earnings report can and sometimes do set up specific trades to capitalize on this effect. I don't. If you want to know why, look at a PCLN chart for this week.
Usually, the price of an at-the-money straddle (a long call plus long put) in the day or two before earnings will tell you how far market makers think the price could move after earnings. They're not always right. I didn't price PCLN's straddle just before its earnings were reported, but I doubt that big of a move was being priced in.
Unless you're experienced with earnings plays or want to experiment with lottery money, avoid options trades on stocks about to report. One reason that I prefer indices to individual stocks is that you might also have to be aware of the earnings report of a competitor or peer. AMD and INTC reports used to impact the other's stock price, for example. Jim Brown recently mentioned the hit that CSCO might have taken due M&A activity in another stock.
Your personality must be considered when choosing a trade. Do you want a sedate trade or does your preferred style or personality require big directional moves? If you want those big directional moves, you want a high-beta underlying. The site you use to find quotes and other information about your underlying will often include the beta value, too. If you want an underlying that jumps around a lot more than the general market does, you want one with a beta larger than 1.00. Many sites determine beta against the SPX. Your brokerage may allow you to beta-weight an individual stock against the RUT or other index, if you prefer.
Does your work schedule allot you some weeks when you're in your office and able to freely monitor your trades and others when you're in the field and unable to do so? Weeklies may be right for you, although trading weeklies requires special skills. There's little comparison to how options perform five weeks from expiration and five days before expiration. Perhaps instead of weeklies, a set-and-go or no-touch trade such as a debit spread on a cash-settled index might be a trade to explore. If you're setting such spreads on equities, you have to worry about assignment risk if you're unable to monitor trades closely as expiration nears.
Let's look at an example of a process a trader might go through to determine a trading possibility. Perhaps you've determined that you don't have the stomach for weeklies. You know yourself well enough to know that you're always going to have some market opinion. You want directional trades where you can put that opinion to work, and you have the patience to wait a week or two or three for the trade to work. Furthermore, you're a techie who lives in Austin and has some knowledge (although not insider knowledge) of what's going on at Dell because you read all the Austin news stories about the company and you understand the industry and the products. Dell has earnings coming up, but not until August 21, so maybe, at the time this was written in mid-July, you had time to experiment with a two- or three-week trade before the implied volatilities get all out of whack. Dell has a beta of 1.41, you learn.
Imagine that you have decided in that mid-July time period that the stock price had been beat up enough that it would likely steady or rise. However, markets had generally been weak, and you know that a market storm will likely sink all stock prices. You would count yourself as only mildly bullish then. You don't want to risk too much testing your theories, either. Note: I do not trade Dell or follow the stock price with any regularity and will not be engaging in or suggesting any trade discovered here. This is about finding the right underlying and vehicle for your needs, not about suggesting a specific trade, which would in case be outdated by now.
Most brokerages these days have some sort of trade-discovery vehicle. OptionsXpress's version is titled "StrategyScan." I input the stock's symbol, the time horizon of one month, a "Moderate Bullish" direction, and an investment risk of $500. The StrategyScan feature spit out three possible trades to consider: a bull call spread, a call back spread, and a long call. However, one of those, the call back spread, was available to me only because I have a high trading level or permissions. It would not be available to someone with a lower trading level. To the trader with a lesser trading level, only the other two options are available.
For the purposes of this discussion, let's presume that all strategies are possible for consideration. Most traders understand the pros and cons of trading a straight long call, so let's compare the other two strategies. We'll start with the overview of the trade's component options, with the top strategy being the bullish call spread and the bottom, the call back spread.
Comparison of the Overview of Two Strategies:
When comparing the two trades in this way, we see that both require the trading of six contracts, so that each would incur the same commission costs. Maximum risks (since Dell doesn't have a dividend) are almost identical. Major differences occur when we study maximum gains and profit ranges, however. If Dell's price were above $11.56 at expiration, plus the amount paid for commissions, the bull call spread would be profitable and would remain profitable as Dell continued to climb, eventually reaching the maximum profit of $432.00 minus commissions.
The picture would be quite different for the call back spread. Here, the trader would be somewhat protected if the market weakened and dragged Dell down from its then current price of $11.51. A credit of $134, minus commissions, was theoretically obtained when the trade was opened, and the trader gets to keep that profit if Dell rolled over and headed down. However, if it were to head higher and stall at say, $14.30, it would be stalling right over what former market maker Dan Sheridan calls the "sea of death." Let's look at charts of the two positions so we have a visual.
Charts of the Two of the Suggested Positions to Be Considered:
The overview of the Call Back Spread pegged the range of the sea of death as $11.67-16.33, and you can see that sea of death in the chart. It's easy to make a decision, then. If you feel almost certain that Dell is going to head higher, but probably won't get above all that possibly strong resistance at $14.00, the bull call spread is the preferable trade among these two. If you feel that Dell is due to either roll over and cascade lower or mount a massive rally over the next month, the second trade is your trade. You're covered if it rolls over.
Or is that all there is to consider? Will this trade be held to expiration?
Going through this process is too lengthy to cover in a single article. We'll take up where we left off next week.