Consider your options

So. Many. Choices—How to pick a strategy

Before you jump into the market, consider your options (sorry, not sorry, we had to say it). Seriously, though, we’ve covered many strategies here in these articles. On one hand, options traders seemingly have limitless choices when you combine every strike, expiration series, and possible strategy. On the other hand, this can lead to paralysis by analysis. To help, let’s start looking at how veteran traders approach their decision making, and how a logical approach to trading can help improve your strategy selection process.

If you’re already trading options, the first step is to assess what you’re doing and whether it seems to be working. There’s a good chance as a new options trader you’re focusing only on buying calls (if you’re bullish), or buying puts (if you’re bearish). That strategy can work in a strong, one-way, trending market.

But what happens when you’re on the wrong side of the market (you picked up, it went down), or when markets become choppy, or volatile (think of a small boat out at sea during a storm)? Long options can lose value quickly if you’re wrong directionally, and your profits can disappear faster than you can toast a bagel. Not to mention, time and implied volatility will always be lurking, waiting to foil the best laid plans.

So, it’s not only worth considering multiple strategies that are designed to mitigate the risks of being “long premium,” but they might actually protect you from, well...yourself. The question is, which strategy do you choose? And how do you go about choosing it?

Why loss, why?

Let’s talk about losses first. Losses on long calls and puts happen for a variety of reasons—namely due to price (the stock went the wrong direction), time (time decay is always your enemy with long options), and volatility risks (you overpaid for an option).

Also, your options don’t trade in a vacuum. Options are tied to stocks, stocks trade in a market, and our markets are interconnected with the rest of the world. Seemingly unrelated events can trickle down all the way to the price of your option, causing losses. Why losses happen is less important than recognizing they likely will happen, and learning how to mitigate them (or at least try).

So, if your best defense is indeed a good offense, plan for the risks and reduce them as much as possible before placing your trade. It starts with picking your optimal strategy, based on current market conditions.

Burning questions

Before making any arbitrary decisions about strategy, make your decision logically and methodically. When you plan your next trade, first ask yourself three questions:

1. Am I bullish or bearish? (Do you think the market is going up or down? Sideways or choppy?)
2. Where in the trend is the stock? (The start of the trend? The middle? End?)
3. Is volatility high or low? (Aka, are options relatively “cheap” or “expensive”?)

Let’s explore these:

Am I bullish or bearish? This addresses price risk and is another way of asking yourself, “What are the stock, sector, and market trends right now?” Short-term traders generally use charts to track momentum of a stock, but it’s worth taking a peek at what the other stocks in the same sector are doing, as well as the market overall. Remember, your options do not trade in a vacuum. An informed trader can be in a better position to “see the big picture” before placing a trade.

Where in the trend are we? This addresses market timing and takes question 1 a bit further. How long have we been in this trend, and how strong is it? Are you looking to make a short-term trade after a seven-day rally in the stock? Are you just guessing things will keep going because that’s what it “feels” like? Or, does the market feel “overheated,” and do you think the crowd is right or wrong?

All of this to say that at some point, trends tire and pause, and prices typically pull back at some point before moving higher (if they move higher). When they do, even a small pause in a trend can cut your long options value in half (or more). An old trading expression: buy enough time, but don’t use it. In other words, consider choosing an expiration for your option trade that’s around long enough to withstand short term fluctuations.

Some veteran traders look to 60 or 90 day options (or longer) to give their trade time to “work” and target 21-30 days before expiration aiming to exit a trade before time decay really kicks in. Anything less than 21 days to expiration generally leaves a very small window to be correct, not to mention the time decay becomes a strong headwind. Short-term options that expire in a day or a week provide a razor thin margin of error, if any at all.

Is volatility high or low? This addresses implied volatility risk, and it’s important to understand the “relative” value of an option in terms of implied volatility (IV). Part of the time premium of an option is solely based on this number, which may seem arbitrary—but it’s not. It’s the quantification of an options supply and demand. If a lot of people want to buy puts on a stock, put prices might rise. If a lot of folks want to sell calls, call prices should fall. It’s like anything else in life, supply and demand for options drives their prices.

Think of your option’s premium like an Uber fare and implied volatility is the surge rate. Ask yourself, when is it a better time to grab an Uber? When fares are at normal rates, or when surge pricing is 8x? Implied volatility on options is kind of like that. If you buy a call or put at 8x surge pricing, there’s a good chance when supply increases and demand for options subsides, it will go back to 3x, 2x, or 1x (but it can also go up to 16x, or more).

The bottom line? High implied volatility inflates option prices. Once you get the hang of this, you’ll start to realize why buying calls or puts with high implied volatility is like paying for an overpriced rideshare.

Building the matrix

To recap, think about asking yourself these three questions:

1. Am I bullish or bearish?
2. Where in the trend is the stock?
3. Is the volatility high or low?

As you begin to answer these three questions for yourself, refer to something like this “strategy matrix” below:

These aren’t recommendations. They’re just assembled here based on what certain options strategies were designed to do under certain conditions. It may be obvious to you that buying a put in a bullish market isn’t a great idea. But if you think the market is about to fall and want to play the part of a bear (short for bearish), put debit spreads are designed for this more cautious approach, for example.

Notice, some of these strategies aren’t very thrilling. After all, waiting for an iron condor to do its thing is about as much fun as watching paint dry. But trading isn’t necessarily going to be thrilling. It’s supposed to be—well, methodical. Some of the best traders in the world spend their day sitting, reading, thinking, and watching. A common phrase amongst traders is, “it’s sometimes best to sit on your hands and wait for the market to come to you.” Once it does, you can be ready with a logical and planned approach to your strategy selection. As an old trader friend of mine always says, “Plan your trade, and trade your plan.” It starts with making smarter choices.

Up next: Navigating exercise and assignment

Disclosures

Content is provided for informational purposes only, does not constitute tax or investment advice, and is not a recommendation for any security or trading strategy. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results.

Options trading entails significant risk and is not appropriate for all customers. Customers must read and understand the Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount.

Robinhood Financial does not guarantee favorable investment outcomes. The past performance of a security or financial product does not guarantee future results or returns. Customers should consider their investment objectives and risks carefully before investing in options. Because of the importance of tax considerations to all options transactions, the customer considering options should consult their tax advisor as to how taxes affect the outcome of each options strategy. Supporting documentation for any claims, if applicable, will be furnished upon request.