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.