How Do I Select The “Perfect” Option?
Whether you’re new to options or a longtime trader, one thing that becomes clear pretty quickly is that there are a multitude of trading choices and strategies.
But the goal is always the same… In an ideal world, you want to select the “perfect” option – the one that gives you the best chance of profiting (preferably with the least amount of tolerable risk).
It may seem overwhelming at times. But first things first: you must identify your intention and time frame. From just those two inputs, you can go down a number of paths to find the best option that fits your intentions. The good news is that we’re going to offer some step-by-step guidelines to help you find the perfect option.
Granted, these guidelines are based on our own experience. At Profitable Trading, we normally stick to a few simple, proven options strategies (long calls and puts, short puts and calls). But we’ve guided readers to successful trades for years with these techniques.
The five steps below will help ensure you don’t get stuck in the wrong option for your trade when you are looking to do this on your own. (Keep in mind that you still need the stock to perform as you expect; these rules simply help with selecting the right option.)
5 Steps To Picking The “Perfect” Option
Step #1: Delta
Delta measures how much an option’s price should change if the value of the underlying security changes by $1. The values of delta will range from 0 to 1 for call options and 0 to -1 for put options.
For our purposes, we prefer choosing a Delta between 0.70 and 0.92 for calls, or -0.70 and -0.92 for puts.
You can deviate very slightly from this rule, but buying an in-the-money option helps remove some of the other variables from the equation.
[Read More: Options 101: Delta]
Step #2: Expiration Date
Add 30-40 days to the maximum you anticipate being in the trade. That’s the expiration date you should buy. Again, this is just our opinion.
Before you start, you must have an idea of how long you anticipate being in the trade. This is imperative when trading options because all options have an expiration date. Be honest with yourself and know your style. If you’re a longer-term trader, buy more time in your options.
Step #3: Bid-Ask Spreads
Just like stock, we usually have to buy at the ask and sell at the bid. The larger the spread, the longer it takes for you to start making money. Think of the bid-ask spread as a commission; if you’re trying to make $0.50 profit on an option, but the bid-ask spread is $0.50, that really puts you at a disadvantage.
Look at the at-the-money options and go three strikes up and three strikes down. If the average bid-ask spread is more than $0.20, use extreme caution. Try to buy options with less than $0.20 between the bid and ask prices.
Try to purchase options with tight bid-ask spreads of less than $0.20. Remember that expensive stocks and expensive options may have higher spreads.
[Read more on how wide bid-ask spreads can kill your performance here.]
Step #4: Option Interest/Options Volume
Open interest means there are already people holding those options (long or short), and they may want to buy or sell them at a point. This is a good thing.
Look for open interest in your option to be greater than 50, although 100 or greater is preferred. Options volume is not terribly important, but high volume is a bonus. The more volume, the better. When you’re trying to buy or sell something, it’s better to have more competition for whatever it is you’re trading. This holds true for stocks and options alike.
Step #5: Total Stock Volume
It’s always better to trade options on higher-volume stocks. Aim for a minimum average daily volume of 500,000. There is no upper limit on volume. Just like with equities, you don’t want to get caught in an illiquid position.
Again, keep in mind that these are just guidelines based on our experience. And if you’re not familiar with some of these terms or strategies, we’re here to help.
Also, take your time to learn and make sure that you understand the basics of what makes the market — and options — tick. It’s never a bad idea to “paper trade” a few times using your broker’s platform, either. There’s nothing worse than wanting to make a trade and not knowing precisely how to do it.
In the meantime, if you’re familiar with how options work, then we recommend checking out our colleague Amber Hestla’s proven system for using options to generate income…
After leaving a career in military intelligence, Amber studied under some of the most highly regarded names in the trading community. And she used what she learned to develop a unique indicator that’s delivered winning income-producing trades more than 90% of the time since 2013…
We just released an updated presentation that explains just how powerful this simple technique can be — and how you can start earning thousands in extra income each month.