3 steps to pick an option strategy

Why isn't trading options like trading stock? You think the stock will go up in price so you buy it and wait, or you think the stock is going to drop like a rock so you short it and rack up the dough. With options you have 40 different option strategies to pick from and that is just the start. After you finally pick the perfect strategy you then have to decide on the right strikes and expiration.

This can be a tedious process which can make or break your whole position. For now we want to focus on which strategies to use in which situation. We run a three step process when trying to decide on how we attack a particular stock which involves recognizing our stock bias, analyzing implied volatility and picking the best strategy from there.

Step #1: Recognizing Our Stock Bias

You've heard the saying, "never put the cart before the horse". Well the same goes for option trading. What you don't want to do is start with the option strategy and try to fit the stock you want to trade to it. There are three different directions a stock can head, up (bullish), down (bearish), or no where (neutral). Luckily with options we can profit from all three of these directions.

Let's discuss all three of these possible biases and the option strategies to go with them. This is our first step to narrowing down our strategy selection.

Before we begin lets note that we are dealing with short term price fluctuations. Typically we trade options for short term movement and not because there is strong or weak fundamentals.

There are two main reasons a stock price will climb. It is either breaking out of a range by busting through resistance or it's coming off a bottom by bouncing off of support. Whichever the case here are the option strategies you want to focus on when you are bullish.

  • Long Call
  • Short Put
  • Bull Call Spread
  • Bull Put Spread
  • Call Calendar Spread
  • Long Ratio Call Spread

Like being bullish there are two main reasons a stock will fall in price. The stock will be breaking through support and falling lower or hitting resistance and priming to move down. When we are bearish these are our go to strategies.

  • Long Put
  • Short Call
  • Bear Call Spread
  • Bear Put Spread
  • Long Ratio Put Spread
  • Put Calendar Spread

Active Value Investing noted, "Over the 100 years from 1900 to 2000, range-bound markets were occurring over half the time." Stocks are in a range more times then they are trending so knowing how to profit in these markets is essential. When you identify a stock that is in a range here are your go to strategies.

  • Short Strangle
  • Short Straddle
  • Iron Condor

Once we have our opinion on the stock direction we have a much more manageable list of strategies to choose from. The next thing we need to do is take a look at where implied volatility is trading so we can narrow our list even further.

Step #2: Analyzing Implied Volatility

"Option traders must have an even greater focus on volatility, as it plays a much bigger role in their profitability--or lack thereof" Dan Passarelli.

Implied volatility is forward looking and show the "implied" movement in a stock's future volatility. Basically it tells you how traders think the stock will move. Implied volatility is always expressed as a percentage, non-directional and on an annual basis. There are several ways we can analyze implied volatility. We can actually track the implied volatility on a chart either through your brokerage or with a sophisticated tool such as LiveVol, or we can use an easier method such as volatility percentile.

Volatility percentile is a ranking method that shows you how the current implied volatility compares to the stock's volatility over the last year. The percentile ranges from 0 to 100 where a reading of 0 would mean implied volatility is at its lowest level, and a reading of 100 would mean implied volatility is at its highest level.

This is better explained through an example.

If The Option Prophet (sym: TOP) has an implied volatility percentile of 37% that means that our current volatility is greater than 37% of the values over the past year. Easy enough, right? Right!

Now that we know what a volatility percentile is we need to know which numbers to look for. When the reading is between 0 and 30 that is a good low volatility reading that we need to trade. When the reading is between 70 and 100 that is a high implied volatility reading that we need to trade. A reading between 30 and 70 means volatility is neither high nor low. When volatility is in the middle it means it won't be on our side in the trade so we will not have an edge in the trade. Let's go ahead and avoid these trades.

What makes implied volatility so beneficial is that it is mean reverting. That means each underlying's implied volatility has its own average value and when volatility stretches too far from this average we can expect it to come back. So when our volatility is too high we want to take a position that benefits when volatility moves lower, and conversely when our volatility is too low we want to take a position that benefits when volatility moves higher.

Now that we know which direction we think the stock will trade and if it is currently high volatility or low volatility we can narrow down our strategies even more.

Step #3: Picking The Best Strategy

Now we can join the first step with the second step and see our strategy selection.

If you are bullish with low volatility:

Long Call. The long call is the vanilla trade of the option world. You are making a sure bet that the stock price will increase. If the stock price increase and you get an increase in volatility your position will benefit much more.

Bull Call Spread. These are debit spreads that are formed by buying one call and selling another call at a higher strike at the same expiration. We use a spread to lower the cost of the position but it means our max profit is limited.

Call Calendar Spread. Time spreads or calendar spreads are more complicated because they involve selling a call option at one expiration and buying another call at the same strike but at a later expiration. Calendar spreads are good if you are expecting a little movement in the underlying opposed to a large move higher.

Long Ratio Call Spread. Anytime you see ratio in options you know you are buying or selling different amounts of options. For this spread you want to sell 1 lower strike call option for every 2 higher strike call options you buy. This trade actually benefits if you get a large move lower or a large move higher. Now if the underlying moves lower your gains will be minimal and capped, but if your underlying moves higher your gain is unlimited.

If you are bullish and there is high volatility, use these strategies instead:

Short Put. When you short a put option you receive a credit for the position, and this will be your max profit. You want to sell a put that is out of the money and then have the underlying stay above that strike by expiration. If that happens you collect your full credit. When volatility drops your position will begin to make money.

Bull Put Spread. Bull put spreads work the same way a short put does except you are selling a put option and then buying another put option at a lower strike. Your max profit will be capped at the credit you receive but your loss will also be capped by the difference between the two strike prices.

When you are bearish and there is low volatility:

Long Put. The long put is the vanilla trade of the option world. You are making a sure bet that the stock price will decrease. If the stock price decreases and you get an increase in volatility your position will benefit much more.

Bear Put Spread. These are debit spreads that are formed by buying one put and selling another put at a lower strike at the same expiration. We use a spread to lower the cost of the position but it means our max profit is limited.

Long Ratio Put Spread. For this spread you want to sell 1 at the money strike put option for every 2 lower strike put options you buy. This trade actually benefits if you get a large move higher or a large move lower. Now if the underlying moves higher your gains will be minimal and capped, but if your underlying moves lower your gain can be substantial.

Put Calendar Spread. Time spreads or calendar spreads are more complicated because they involve selling a put option at one expiration and buying another put at the same strike but at a later expiration. Calendar spreads are good if you are expecting a little movement in the underlying opposed to a large move higher.

When you are bearish but volatility is high, go for these strategies:

Short Call. When you short a call option you receive a credit for the position, and this will be your max profit. You want to sell a call that is out of the money and then have the underlying stay below that strike by expiration. If that happens you collect your full credit. When volatility drops your position will begin to make money.

Bear Call Spread. Bear call spreads work the same way a short call does except you are selling a call option and then buying another call option at a higher strike. Your max profit will be capped at the credit you receive but your loss will also be capped by the difference between the two strike prices.

When you are neutral with high volatility:

Short Straddle. When you are absolutely certain the stock is not going to go anywhere you want to use a short straddle. These positions are created by selling a call option and a put option at the same strike (typically at the money) and expiration. You will collect the full credit if the underlying stays at the strike price by expiration. If the underlying makes any large moves at all this position will be a loser. This position will benefit greatly if volatility begins to drop.

Short Strangle. A short strangle is a lot like a short straddle but now you are selling a call option that is out of the money and a put option that is out of the money, both at the same expiration. This strategy is going to give you a wider range that the stock can move while still holding a gain but will lower your profit potential.

Iron Condor. An iron condor is an advanced strategy because it requires four different options to be placed. Basically you will be selling a bull put spread and a bear call spread at the same expiration. This creates a wide range for the stock to move (like a short strangle) but instead of having unlimited loss potential like the short straddle and short strangle your loss will be capped.

How about when you are neutral and there is low volatility? In this case you don't really want to place any trades. You have no real advantage if you try a short straddle, short strangle, or iron condor in this situation. If volatility begins to rise it will cause losses in all of those positions. These are trades you want to avoid because there is no edge.

Conclusion

Instead of trying to comb through 40 different strategies every time you want to place an option trade you can use this method to make sure you have the right strategy for the right situation. Anytime you can trade with an edge in your favor you are setting yourself up for long term success. Once you have your bias on direction you can look at implied volatility percentile to tell you if volatility is high or low. From there you will have 2-3 strategies you can pick from that all take advantage of your stock's situation.

How do you know which strategy to go with between those 2-3 depends on what you think the stock will do. Bullish, low volatility, and you think the stock is going to rocket in price? Go with the long call because you will benefit the most. If you think there is a good probability the stock will move a little higher then resort to the bull call spread instead. This will allow you to test the waters but not cost you as much.

Remember if your implied volatility percentile is between 30-70 or if you are neutral and the percentile is between 0-30 go ahead and skip those trades. These situations don't give you an edge and don't set you up for long term success.

round testimonial

"Last year The Option Prophet absolutely transformed my trading account from one where monthly gains were often uncertain and unpredictable into one where a steady monthly income stream through OTM credit spreads bought amazingly steady and consistent growth."

-Andrew B. 

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