Follow Us: TwitterFacebookRSS feed

Which Option Strike Price Should I Trade?

Posted by Pete Stolcers on February 13, 2008

Option Trading Question

Can you blog about the strategies that you use to pick the option strike price and expiration month once you have identified a possible stock? Also are there any tools out there one can use to identify possible profit and loss and probability of success for option trading?

Option Trading Answer

Throughout my blog you will find that your option strategy is a function of your opinion. You have to nail down the direction, duration and magnitude of the move. Then you need to assess your confidence in; the market, your analysis and your recent performance. All of these factors will lead you to the optimal strategy and trade size.

If I have a long term grinding move in a stable stock and the market is neutral, I would probably opt for an ITM call that has a few months of life. I will be buying intrinsic value and the option will move point for point with the underlying. This gives me the latitude to take profits along the way. This is almost like a surrogate stock position.

If I am looking for an explosive move in a short period of time, I will buy a front month OTM option. That will give me the biggest bang for my buck and I can buy more contracts.

If I am fairly confident in the stock’s strength, but the market is volatile (like now), I might consider selling an OTM put credit spread. This strategy will give me more cushion. If the market moves against me, the stock should hold up well and the puts will expire. If the market falls apart I should have time to buy back my put spread before things get ugly.

I trade relative strength and weakness within the market - that is my edge.

As for software, OptionVue has very good scenario analysis software. It will calculate your P&L based on many different outcomes. For most traders, this software is overkill. I like to keep things simple.

Know your stop before you place the trade. If your forecast was wrong, get out. When a trade is profitable, start getting out when the move stalls. Predetermined targets will often leave too much money on the table and you need to let your winners run as long as they are behaving.

Option Trading Comments

  • On 03/07, BounFor Hell said:

    The trades that worked for me in the past I traded close to the In The Money Option chains. The further out the expiry date better, but I often settle for one to three months. 

    If you pick the one-month option chain then you better be sure that the trend and market trend are going hand in hand. Common sense dictates that you cannot short in a bull market unless there had been some material change in the company. Always trade with the market because itís a well know fact that at least 70% of the stocks follow the market trend. 

    One month or less options are not for the faint of heart, but if they go your way you will get richly rewarded. 

    Two, three and four month out expiry date options are a lot better because change comes slowly and you have time to get out if the trade did not go your way. Two to three month options close to the In the Money Option chain are the way to go. 

    Example:
    Stock XWZ is currently in a downward trend, the market ( DOW, TSX,) or whatever market you are trading is also in a bear trend.  The stock is at $19.50, the next available chain that is out of the money for PUTs is $17.50 that would be the chain that I would consider buying.  Now you need to decide which chain will give you the best bang for you initial outlay >>> two, three or even four months out expiry dates.  They are differences in the delta and liquidity in each chain. I tend to pick the chain with the most liquidity and also look for the BID and ASK spread to be close together.

    Because this worked for me in the past, I now try to abide by the above game play.

    Good Trading
    BoundForHell

  • On 03/08, Mladen Nadj said:

    Whay Options are not traded at extended and pre market hours.
    Are options prices adjusted automaticly on opening of the market acording to stock move in premarket trading?

  • On 03/18, Options View said:

    First of all this is one of the best blogs on the options market on the web.

    I trade options in emerging markets and things work bit differently. This market provides good opportunity to make easy money selling far OTM even when it is few days left to expiry as you will always find buyers.

    I look at my trading strategy from combination of time decay and volatility point of view. Many investors in Asia look at the option price price perspective - a 30$ ITM is always expensive options compared to 2$ OTM with high I vols.

    visit my blog:

    www.optionsview.blogspot.com

  • On 07/16, Mark said:

    I want to let you know that you did a great job with this blog. I have a bloomberg terminal, and wanted to know if that has all the neccesary software for options trading?  Ive heard alot about optionvue but have never used it are there any advantages to using it instead of bloomberg?

  • On 07/17, Pete Stolcers said:

    It has been 6 years since I have used a Bloomberg terminal, but they have it all. I can’t imagine needing anything else.

    OptionVue is nice if you do a lot of neutral trading (which I do not advocate for retail traders) and you have complex spreads that require risk analysis. It allows you to do extensive sceario analysis.

  • On 07/22, OptionsView said:

    When it comes to analyzing Options, Bloomberg is the best. Why? for few reasons:

    1. The Idea generating Tools
    2. The Calculators
    3. Volatility data and analyzing tools
    4. Ability to integrate the fundamenta, technical and options data to generate trade ideas.
    5. The live news

    thx.

    optionsview

  • On 07/31, Pete Stolcers said:

    Yes, for those who can afford it, Bloomberg is excellent.

  • On 10/21, Julie said:

    I only want to buy Calls or Puts, as replacements for buying or selling the stock.
    Is the following correct?
    3 to 4 mos. out
    Tight spread
    1 strike ITM
    Good Volume and Open INt.
    These would be 1 to 3 week trades.  Thank you.

  • On 10/22, Pete Stolcers said:

    You can’t generalize when it comes to option trading. Your opinion of the market and the underlying stock determine the right strategy. Be flexible, the market is ever changing and there is no one size fits all strategy.

    Please use the search feature tp find related articles and you will get a feel for my approach.

  • On 02/03, Linda said:

    how does buying an option a MAY 15call and selling MAY 20 CALL TO NFINACE ( COH) WHAT DOES THIS MEAN AND WHAT IS THE RISK?

  • On 02/04, Pete Stolcers said:

    When you buy a closer to the money call option and sell a farther out of the money call option you are creating a bullish call spread or a call debit spread. The option premium you receive for the father out call you sold reduces the purchase price of the closer to the money call you bought. Your risk is limited to your net debit (option bought less option sold). Your max profit is capped off to the difference between the stike prices less the credit you received. In this case, let’s say you paid $1 for the spread. Your max profit would be $4 ($5 between the strike prices - $1 net debit). Option spread strategies are very effective.

  • On 03/26, maria said:

    If you are someone who ascribes to the efficient market hypothesis, what would be your opinion active vs. passive management?

  • On 03/26, Pete Stolcers said:

    You would be passive of course. Efficient market theory suggests that all news is priced into the market and one can not possibly forecast random movement. You would scale into a diversified portfolio of assets with that mentality using structured time frames and constant capital.

    Fortunately, I do not subscribe to that theory and I make money timing the market and individual stocks. I can find mispricing everyday and so can you. All you have to do is look to at the number of stocks that gapped higher or lower. They are out of equilibrium and they do not instantly find the “right price”. There is a discovery process. Trends and other technical indicators have been proven to work and they are another example of how you can predict price movement.

  • On 06/10, Brian Shimek said:

    How close to the asking price can you set your limit and what is the difference between bid and ask price?

  • On 06/15, Pete Stolcers said:

    If you divide the bid/ask spread by 4, you can usually sell a quarter above the bid and buy a quarter below the offer. For instance, if the spread is $.20, you should be able to sell a nickle higher than the bid and buy a nickle lower than the offer.

    The bid is the price someone is willing to buy the option at. That is where you will be selling it. The offer is the price someone is willing to sell it at. There is where you will be buying.

    Another factor is the direction of the stock. If it is moving higher and you are trying to sell a call, you can do better. People are trying to buy those options and they will pay up. On the other hand, if the stock is tanking and you need to bail on your calls, you might have to hit the bid.

  • On 09/10, sanjeev said:

    hi pete,

    i have learnt much from your analysis and blog. thank you!

    i am a retail trader, and have a unresolved question about strike price.

    i do swing trading, and typically hold 2-15 days. i trade stocks over $100 like Apple, and usually buy OTM naked calls, since I can only afford options that are less than $3 per contract.

    many times, i find that if stock moves in my favor, the MM simply drop the volatility on no news and rob me of gains. of course, if the stock moves against me, then i have hell to pay.

    as an example, earlier this week, i bought front-month $400 September call for Apple this week and paid $1.43 per contract. Next day, Apple was up $4 but MMs dropped the volatility and instead of profit, my calls lost 10c to trade at $1.33 per contract. Even if I had bought Oct expiry calls, I saw that those calls also lost value.

    How do I (i) trade stocks over $100 (ii) not bet more than $300-$500 to establish my position and (iii) and not let MM rob me of gains by dropping volatility when stock moves in my favor.

    Thanks for your insights.

  • On 09/12, Pete Stolcers said:

    If you feel that implied volatilities are high (as they are now), you have to be a seller of options. Learn how to credit spread. The answer to your question is that simple. The Market Makers are not your problem, it is simple option price behavior. Always remember there are two sides to every trade.

    Secondly, you can move farther out in time to reduce time decay and IV declines. Stay away from front month options if you are buying premium.

< Back