Perhaps you've mastered a neutral trade strategy, and you're ready to branch out and try some speculative directional trades. Perhaps you're an options newbie, but you familiar with the behavior of a couple of stocks and ETFs, and you think you would be pretty good at choosing a direction. In either case, where do you start looking for new trades to test? Notice that the idea is--always--to test a new trade, or, if you don't have that capability, to try it in very small allotments at first.
I believe you begin by asking yourself about your risk tolerance, both in terms of money and time. For example, a trader comfortable with having $1,000 at risk in a new or speculative trade for a day or two might find himself uncomfortable with the idea of having that amount of money at risk for three weeks, when the market tenor might have changed.
Then determine if the vehicle you've chosen has options, and take a look at the open interest (OI) and volume with those options. Perhaps compare the open interest and volume to that seen with the options of a frequently traded vehicle such as AAPL or the IWM.
You likely will not find that your vehicle has as much open interest or volume, but you will at least have a benchmark for what constitutes a liquid options markets. When I used to trade one vehicle more than a decade ago, I used to swear that when I put in my options order, a little bell dinged somewhere in the deep recesses of the CBOE and the only market maker for those options woke, yawned and then ambled out on the CBOE's floor to see if he felt like taking my order.
I'm familiar with the RUT, so if I wanted a new, low-cost speculative trade on a familiar vehicle, I might try it out on the IWM, the ETF related to the RUT. Let's look at a price graph for the IWM. Remember that these Options 101 articles are roughed out a week or two prior to the articles' publication, so price and other graphs are not current.
IWM on Wednesday, February 19, 2014, Close to Midday:
While I was not at all certain what would happen with the RUT or the IWM that day, let's imagine that I was unreservedly bullish and thought the IWM might climb all the way through the Keltner channels to touch the top of the pink channel, as it had several times over the previous months.
I could then have plugged this information into the CBOE's (Chicago Board Options Exchange) free Trade Analyzer, found under "Tools" on the CBOE's main page. Many online brokerages have similar and, in many cases, more user-friendly and complex trade builders. However, for the purposes of this article, I wanted to use a generic trade builder that would be available to everyone.
Plugging Hypothetical Information into CBOE's Trade Analyzer:
Notice that, since I was assuming that the IWM would climb, I also built in the assumption that the implied volatility for IWM options would fall. When I originally captured this screenshot, the target price had not been reset to my upside target, but that number was changed in the trade calculations shown below.
Some of the Suggested Trades:
Partial View of P/L Graph for the Suggested Strangle:
Size limitations for publication did not permit the inclusion of all the information on the expanded view of this strategy. This snapshot does detail the options that would be part of the strategy as well as part of the P/L chart for March 15. We can see that the target 119.92 price is included on the price line. The interactive chart allows a trader to scroll along that line and determine that the hypothetical profit would be $856.42 or 89.77 percent of the $954.00 cost basis (without commissions, I believe).
The trader can compare this strategy with many others offered. The trader can also compare all the options strategies with the strategy of buying 8 shares of IWM for a cost of $920.08, the benchmark position the CBOE utilized for comparisons.
In all, the CBOE offered ten strategies that met the input parameters. I could compare the probabilities of profit of each trade and the outlay. What if it was my expectation that, if the IWM failed in its attempt to move higher, it would instead likely tumble lower, and would fall fast? Perhaps, if I had that kind of scenario in mind, the strangle wasn't a bad choice. If it was my opinion that the IWM was more likely to stall near $110-111 for several weeks if it couldn't make headway toward $119.92, then I might not think the strangle was such a good idea. In the case of a stall, the IWM would then be sitting in what some traders call "the valley of death."
Even if you're an experienced trader just looking for a good speculative trade, it's sometimes a good idea to go through this sort of exercise. Perhaps you were a straddle or strangle trader a long time ago, but you'd forgotten how much you liked that trade. Unless traders are experienced with the chosen trade, however, it's best to stick to simulated trades or small trades with monies set aside for speculated trades. Just because a trade analyzer suggests a trade doesn't mean it's the right trade for you, but such exercises might help you find one to add to your repertoire of options trades.