Basics of options
They are contracts to buy or sell a stock or ETF, also known as their underlying assets at a specified date for a certain premium.
There are two types of options, a call option, and a put option. A call option gives the buyer the right to buy the underlying at the expiration at the strike price and the put option gives the right to the buyer to sell the underlying at the expiration date.
The Upside to Buying Call and Put Options
A major upside of buying a call and put options is that they are low in cost. One doesn’t have to buy the underlying to participate in the price fluctuations. The trader can enter the contract with just a premium which is a small amount. Instead of controlling the underlying, here we can
Another major reason upside in buying options instead of buying the underlying is leverage. leverage. For a very small percentage of the actual price of the underlying stock, traders can control a substantially larger number of shares instead.
Another reason why options are preferred to stocks is less risk. We already know the losses we’ll endure if any, beforehand which comes as a major advantage. In options, losses are limited to the premium paid whereas if we purchase or sell short the stock instead, we can potentially lose more than we originally intended or planned on that specific trade.
Choosing the Right Call Option
A trader has to factor in various aspects while deciding which call option to buy. One of the biggest mistakes that rookie traders make is focusing on the price of the call option, instead of the ultimate objective or the reason for purchasing the call option. The better way to approach this question is to determine exactly what the call option is worth and how much value we can gain from the option that we are interested in purchasing.
The biggest factor that should go into deciding which call option to purchase is to consider the anticipated movement in the underlying asset and the timing for that movement, only then can we reasonably determine which option we should purchase.
There are three main types of call options.
I. Out of the money
This is the cheapest type of call option. The strike price for the option is substantially above the price of the underlying asset. If a trader feels that there will be a very strong move within a relatively short time in the underlying asset, they may go for it.
II. At the money
This particular call option is purchased when the buyer is expecting a medium-sized move within a relatively short period. The at the money call option is a popular choice for swing traders because it doesn't require a very strong move to begin gaining value, unlike an out of the money call option.
III. In the money
The in the money call option is purchased when the call buyer is expecting the option to move very close to the movement of the underlying stock. In the money call option is a viable choice when the underlying stock is expensive and the trader wants to participate in the movement of the underlying stock but doesn't want to incur the downside risk or exposure that comes with owning the actual asset and doesn't want to spend or doesn't have a large enough account to purchase the number of shares that are needed.
In addition to deciding which strike price, you should purchase; the second part is deciding on how much time you will need. You have to keep in mind that options decay or lose a major portion of their value during the last month before expiration, so I don't recommend you purchase call options that have less than one month till expiration unless you are expecting an imminent price move in the underlying asset.
If you are day trading or swing trading and intend to hold the call option for a few hours or a few days, then buying options with less than one month of time value may be a viable choice, since the less time value the option holds the option will be cheaper, because the odds of it expiring worthless are high.
But on the other hand, if you don't know or have a good sense of how long it may take for the underlying asset to begin moving, then it may be a good idea to purchase a call option that has a few months till expiration. This way the option will decay slowly and give you a bigger time window for the underlying asset to make a price gain that's needed for the option to move higher and ultimately gain more value, which is our ultimate goal.
Choosing the Right Put Option
Unlike most traders who only focus on making money when underlying markets move higher, seasoned and professional traders focus equally on both sides. When we purchase a put option, we plan to profit when the underlying asset declines in price. The more the price declines, the more value the put option gains. During prolonged bear market cycles, when markets continuously decline over time, buying put options is one of the best strategies.
If a stock trader feels that the current position of his stocks is going to decline in the future because of low earnings, he can mitigate the downside selling pressure that the stock is going through buying a put option.
Similarly, put options can also be used to hedge against strong downside market moves that can impact a trader’s existing market position.
One of the best indicators is scanning for assets that are making 90-day price lows. According to extensive backtests, assets that trade at the 90-day price low, tend to continue moving lower over time
There are three different types of put options: at the money, in the money and out of the money.
A put option is at the money if the strike price of the option and the price of the underlying asset are on at the same price level.
The most expensive put option is one that's in the money because, in addition to time value, the option also holds intrinsic value, which in addition to time value, is the second biggest factor that determines the price of the option; with volatility being the first.
As the strike price moves from being in the money to being at the money, the price of the option decreases, because the option does not have intrinsic value, but because the option is on the verge of being in the money, the price of the option is lower than the in the money option.
The lowest price put option is the out of the money put option, where the strike price of the option is below the price of the underlying asset. This type of put option holds no intrinsic value and has the least chance of ending up in the money at expiration.
When deciding which put option to purchase, traders should always take into account the worst-case scenario as well as the potential upside.
Important Trading Tips for Options Buyers
I. Trade in The Direction of The Major Trend
He suggests that trading in the direction of the overall trend lowers risk, increases the size of gains and percentage of profitability. To determine whether or not the underlying asset is trading in an uptrend, simply confirm that the underlying asset is trading above both the 200 day and 50-day simple moving average. Similarly, to confirm that underlying is trading in a strong downtrend, the asset must trade below the 200-day simple moving average.
II. Don't Use Stops and Market Orders
Not realistically taking into account the length of time you intend to stay in the position is equivalent to trading the underlying asset and not using stop-loss orders to protect against the unforeseeable risk of loss.
Setting guidelines for how long you intend to hold the long options position will force you to cut your losers quicker.
III. Monitor VIX Level Daily
Most stocks and ETF's have a high correlation to the overall market, so in addition to comparing the implied volatility level of each stock or ETF that you trade, you should also examine the volatility of the overall market, since it will have a major impact on the price of the option that you are trading.
IV. Know the Option's Delta Ahead of Time
Buying options with low Delta will cause the option's sensitivity to be extremely low in comparison to the movement in the underlying asset. Therefore, I recommend you purchase options that have a minimum Delta of .50 for call options and -.50 for put options.
V. Implied Volatility Levels Must Be Low
Implied volatility represents the expected volatility of the underlying asset. Implied volatility is directly influenced by the market's expectation of the underlying asset's degree of movement as well as direction. Options that have high levels of implied volatility will result in expensive option premiums.
Conversely, as demand for an option diminishes, implied volatility will decrease.
Always check the implied volatility level on the underlying asset before purchasing options, because if implied volatility levels on the underlying asset are high, the odds are strong that the options will be expensive and if implied volatility on the underlying asset is low, you will find that the options are priced lower.
Swing Trading Options Strategies
Options Volatility Is the Key to Success
With options, the most important factor is not market direction, but the future perception of price or implied volatility which shows the market’s opinion of the stock’s potential moves, or the market's expectation of the future.
Buy Puts When Premium Is Low
Buy put options when the stock begins breaking down. The put options would have so little volatility that even if the market went against you for a day or two, the option wouldn't volatility would be so low that the options price would most likely not decrease too much.
Buying Calls When Premium is Cheap
If you bought a CALL option around the time the market bottomed out and even if you were off by a few points, the volatility would be so low on the option that it would barely go against you.
Keep Swing Trading Options Strategies Simple
Implied volatility is not something you can ignore and it can take on a life of its own and distort the true value of your options contract.
Quick Tips to Better Options Trading
Options liquidity is generally 10% to 20% of the underlying asset and that makes it necessary to use limit orders at all times, regardless of the option that you are trading. Avoid purchasing options that are very far out of the money because they appear to give a high degree of leverage, but the odds of them expiring in the money is an incredibly low majority of the time.
The impact of implied volatility on the price of options can be substantial and can completely distort and grossly over-value the price of an option. Therefore, you should know ahead of time the implied volatility level of each option before you initiate either a long position or a short position.
Before you begin trading exotic strategies, learn and focus on simple positions that don't require numerous options to form a spread. Combination spreads that hold several long and short positions rarely work out and will end up costing you more commission than the potential profit on the trade.
Day trading options may seem like a viable choice, but liquidity levels make the spreads between the bid and offer unusually large and can cause you to risk much more than you originally intended when entering the trade as well as the profit potential that can be gained by opening the trade and closing the trade during the same day.
If you are a directional trader and buy options, consider entry methods that rely on low volatility levels or pullbacks instead of breakouts.
These entry methods rely on low levels of implied volatility and when the underlying asset breaks out and begins moving, the option begins increasing in value very quickly; because implied volatility levels increase drastically, making the option overvalued and undesirable for buyers.
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