Selecting a strategy is the first step when trading in options. The second step is finding the security on which to purchase or write an option.
INVESTIGATING OPTIONS
When choosing a stock to purchase, you most likely look for a company with growth potential or a strong balance sheet. A company whose stock price you think will rise over time or one that will pay regular dividends. But as an options trader, you might be looking for a company whose stock price will rise or one whose price you think will fall or will stay within a range in a finite interval of time. You should be able to correctly predict whether the price will rise or fall, and by how much. Buying/shorting stock allows you an unlimited amount of time to realize a price gain. As an options holder or writer, you need to accurately predict the speed with which the stock price will move, as well as how far and in which direction.
APPLYING RESEARCH
There’s no one best research method for trading options any more than there is when trading stocks. You might prefer a technical analysis, which emphasizes an assessment of price trends and trading patterns in market sectors or overall markets, or consult a fundamental analyst, who studies the particulars of a certain company. For example, INVESTOR 1 and 2 are both interested in the stock of corporation ABC. They know that a quarterly earnings report will be released in a month, and they’d like to predict whether the stock will rise in response to a good report, or fall in response to low earnings—though, of course, it could do something they don’t expect. They both conduct further research. INVESTOR 1 prefers technical analysis, and looks at statistics such as the market’s moving average and the recent performance of ABC’s sector, to gauge the overall outlook of the company. INVESTOR 2, however, relies on a fundamental analyst who looks at ABC’s recent product launches and analyzes the performance of its CEO to predict the nature of the earnings report. Both INVESTOR 1 and INVESTOR 2 could use their research to estimate whether the earnings report will be good news, neutral, or bad news for ABC and whether the stock will rise or fall in the months after the report’s release. How you apply your research will depend on your style of analysis, as well as your own experience with investing, your knowledge of the stock market, and your intuition. Many experts recommend that you use elements of both technical and fundamental analysis when researching equity, to get a balanced perspective.
ACCEPTING RISK
No matter how well you’ve researched the trade that you executed, there’s always a probability that the trade will go wrong. Some it is recommended that you consider the probability of the success of a particular trade. Probability is based on many factors including volatility. Since an out-of-the-money option on an underlying instrument with high volatility is more likely to move in the money. So it’s important to estimate the probability of success before committing yourself to trade. You’ll have more realistic expectations and a better sense of what you stand to gain and to lose.
MANAGING YOUR CAPITAL/MARGIN
How you’re going to manage your capital is another important decision to make before you trade options.
• If you’ve already used up your capital, you’ll have to reallocate to free up capital for options. It is recommended that you use options to complement a diversified investment portfolio instead of dedicating your entire trading capital to options.
• If you’re not very experienced, you might consider trading options with risk capital only, or money that you could tolerate losing entirely, particularly when purchasing simple puts or calls.
• You should also consider the impact that trading options on margin will have on your cash allocation. If you write an uncovered call, you’ll have to deposit a minimum percentage of the value of the underlying shares into a margin account with your broker. This might mean tying up funds that you would have invested elsewhere.