I prefer the same trade every month, a trade that I know in and out. That boring sameness would drive other traders batty. No matter what kind of option trader you might be and how experienced or inexperienced you might be, you're going to hear about other trades that perhaps deserve investigation. How do you begin to evaluate them?
First, you have to decide how much you want to risk while investigating a new trade and what vehicles you feel comfortable trading. For example, trader with a $5,000 account and interested in testing a new RUT-based butterfly would probably do best utilizing a 3-contract IWM fly rather than a 3-contract fly on the RUT. Someone who wants a sedate trade would likely not be comfortable with an options trade based on a pharma stock soon due to report on its latest drug trial. Someone addicted to adrenaline and knowledgeable about the pharmaceutical industry might love that very trade.
To find a new trade to evaluate, let's use CBOE's free (with free registration) TradeBuilder with Trade Analyzer tool. Any trader hanging around in any trading chat room is likely to hear about trades on AAPL, so let's use AAPL as the potential underlying. Employing AAPL satisfies our next condition when we're evaluating a new options trade. The following snapshot of a partial options chain provided by Think-or-Swim shows ample volume and open interest available in AAPL options that were then 51 days out from expiration. Remember that my articles are fleshed out well in advance of publication, so these figures may or may not be similar to current conditions.
Partial Options Chain for APPL, TOS Chart:
This AAPL option chain's columns include volume and open interest. Those listed call options, then 51 days out from expiration, showed plenty of volume and open interest. AAPL options had the liquidity that is necessary to feel some safety in trading an options trade. Long, long ago, I used to trade options on the XAU. Back then, it sometimes felt as if when I placed my order to exit the trade, someone had to go search the back rooms and pull the XAU trader back to fill my order. I had to buy at the ask and sell at the bid. That's no way to trade options, I soon learned. It doesn't matter how good you are at predicting where the underlying's price might go if you're not able to easily slide in and out of your options trade. One of the first steps in investigating a new options trade should be determining that the underlying's options have enough volume and open interest to provide some liquidity. Reconsider trading a vehicle's options when those columns are showing a volume of 7 and open interest of 50.
Before jumping into a new trade on an unfamiliar vehicle, it's also important to check whether the underlying has an upcoming earnings announcement or product introduction that might impact the stock's behavior. AAPL will report earnings again in January, perhaps shortly after the time of January expiration.
Let's let the CBOE's tool set up a hypothetical trade for us and then evaluate it as if we had heard about this trade on one of the chat's or promoted in someone's sales literature. This CBOE tool requires some inputs, including a price outlook and an amount available for the trade. Let's imagine that the person suggesting this trade to you believed that AAPL would probably climb into its late January earnings, but first it was due for a short pullback to about $115. Remember that this is not a trade suggestion but just a hypothetical situation proposed more than a week before publication of this article, on November 28 in this case. Therefore, let's look at AAPL's daily chart as it existed when this article was first drafted.
Daily Chart for AAPL, Just after the Open, November 28, 2014:
Inputting the described scenario into the CBOE's free TradeBuilder tool generates several possible trade suggestions. We can imagine that one of those was a trade suggestion that we heard bandied about in a trading chat room, one that we might not yet have tried but that appeared interesting.
Trade Suggestions Generated by CBOE's TradeBuilder Tool:
Each of these was generated with the idea that $2,000 or less would be tied up in a speculative trade for the purpose of testing a new idea. That's so that we can compare apples to apples, pun intended.
Perhaps you're a dedicated butterfly trader ready to expand your repertoire or a newbie trader who wants to explore a first complex options trade. What are the pros and cons of the first two put and call spreads? Each appears to have similar expiration breakevens, profit potential and maximum risk, so let's delve into only one, buying a put spread.
Expansion of Put Spread Suggestion, Snapshot from CBOE Page on November 28:
Sizing requirements rendered the chart legends fuzzier than I would like, but perhaps this chart remains usable enough for our requirements. This snapshot shows the options chosen to construct the position in the upper left-hand side of the graph, buying 14 DEC-14 118 puts and selling 14 Dec-14 113 puts. This spread creates a debit spread that was estimated, at the time, to cost $1,960 to initiate, but this does not include the commissions to both enter and exit the trade. If AAPL should drop to the targeted 115 by about Dec 9, the estimated profit would be $1,644.82, minus commissions.
Does risking $1,960 (plus commissions) to make about $1,644.82 (minus commissions) appear to be a workable trade? For some traders, it would be. It's an almost an equal risk/equal reward type of trade, and those who feel strongly about their directional trading skills might like such a trade since risk is well managed.
Others might believe that AAPL was due for a pullback to about $115 or maybe even lower before attempting another bounce but might not feel at all certain of their supposition. Perhaps they thought that AAPL was ultimately due for another bounce, and they were not at all certain that any minor pullback would occur before the middle of December. Perhaps the ordering of AAPL's moves would be different and there would be a big push higher and only then would a natural and to-be-expected, several-point pullback occur. Would this trade be good in that case?
That depends on the trader's purpose in initiating the trade and the proportion of the trader's total trading funds that $1,960 risk represented. If the trader had a $5,000 account, was not certain of his ordering of "slight pullback, then bounce" what-if scenario, this equalish-risk/equalish-reward trade would probably not be a good idea. If the trader regularly traded RUT or SPX butterflies, investing $30,000-50,000 of a $75,000 account in each month's trade, and wanted to begin expanding into AAPL trades to get the feel for the way the stock acted, then perhaps this equalish-risk/equalish-reward trade might be a good way to test a live trade.
These are some of the steps an options trader might go through when evaluating a new trade. The list isn't exhaustive, but I wanted to illustrate with possible real-time (at the time the article was roughed out, at least) trade setups.
I still prefer trading a single trade that I know well. However, trading conditions change from year to year, and the trade that worked well in 2000-2005 might not work so well in 2015-2020. Read about other trades. Run some what-if scenarios before you leap into a trade you heard about on a trading chat, via CBOE's TradeBuilder or even on our pages. Question whether such trades meet your trading goals, your outlook and the amount you want to put at risk in learning a new trade. The trade that's perfect for me might not be a good fit for you, and vice versa.
In conclusion, some of you may have noticed that AAPL did hit 115 since this article was roughed out but before publication of this article. It hit that level earlier than the earmarked date assumed on these charts. It was at 115 at some points on Monday, December 01. When two-way commissions were added in, the theoretical profit on the outlined put spread position was $1,596 when AAPL was at 115.12 at 2:31 pm CT on Monday, December 01, 2014. Later in the week, I saw theoretical profits above $1,800.
Implied volatilities had jumped more than the mild climb from about 20 to 22 percent that I had theorized. They were at a composite 27.59 percent according to OptionNET Explorer's calculations. Kinda wish I'd jumped in rather than written an article about evaluating a trade!