Options can be used to actualize a wide cluster of trading strategies. This ranges from plain-vanilla call/put buying or writing, to bullish/bearish spreads, calendar spreads and ratio spreads, straddles, and strangles. Options are offered on a vast scope of stocks, currencies, commodities, exchange-traded funds and other financial instruments. For every asset, there are many strike prices and expiration dates available. Nevertheless, these same advantages also pose a challenge to the option beginner, since the wide variety of choices available makes it hard to identify anappropriate option to trade. The following are critical and logical factors that make it easier to pick a specific option for trading.
The beginning stage when making any venture is your investment objective, and option trading is no different. What objective would you like to accomplish with your option trade? Is it to speculate on a bullish or bearish view of the underlying asset or is it to hedge potential drawback risk on a stock in which you have a critical position? Is it true that you are putting on the trade to earn premium income? Your initial step should be to define what the target of the trade is. This is because it forms the foundation for the subsequent steps.
The next thing is to consider your risk-reward payoff which is reliant on your risk resilience or appetite for risk. In the case that you are a conservative investor or trader, then aggressive strategies such as writing naked calls or buying a large amount of deep out of the money (OTM) options may not be favorable to you. Each option strategy, including the straddle option, has a well-defined risk and reward profile. Therefore, it is prudent to make sure you understand it thoroughly.
Implied volatility is the most essential determinant of an option’s price. This implies that it is vital to get a good read on the level of implied volatility for the options you are considering venture into. You should take ample time to compare the level of implied volatility with the stock’s historical volatility and the level of volatility in the broad market. This is because this will be a key factor in identifying your option trade/strategy.
Implied volatility tells you whether different traders are anticipating that the stock should move a lot or not. High implied volatility will push up premiums and in turn making writing an option more attractive. This assumes that the trader thinks volatility will not keep increasing which could also increase the chance of the option being exercised. Low implied volatility means less expensive option premiums which is good for buying options.
Since you have recognized the particular option strategy you want to implement, you should establish option parameters like expiration, strike price, and option delta. For instance, you might need to purchase a call with the longest conceivable expiration but at the lowest possible cost, in which case an OTM call may be suitable. On the other hand, if you desire a call with a high delta, you may prefer an ITM option.