During the past 12 months, we’ve covered a lot of territory, and I hope it hasn’t been too complicated. Options trading is a big subject. There are many moving parts. And, if you try to learn all of them, before you put on your first trade, you won’t get far in the process. And what good would that be? You didn’t come to my blog to be bored by all the minutiae. You want to learn how to trade options.
My intention in creating this website has always been to provide information that you can use to be able to trade on your own.
My goal for the next few weeks is to take you on a journey from building and executing a trade to managing and closing the trade. I’ll try to keep it as simple as I can. Be sure to check out the highlighted links to further discussions.
Initially, let’s take a look at this from the perspective of building a trade.
So, how do we build a trade?
Setting up a trade properly is key to successful trading.
The most important factors to consider in building a trade are:
- Develop an assumption about direction
- Consider the ideal implied volatility environment
- Identify the best expiration date for your trade
- Understand the risk profile. This involves an introduction to delta and the probability of an option being in the money by expiration.
Let’s discuss these four factors
1. A directional trade assumption comes in three flavors:
We can say our strategy is bullish if we assume that it will profit from the underlying increase in value. Or bearish, if we believe our strategy will profit if the underlying decreases in value, and our assumption is neutral if the strategy we choose profits from underlying price stability. Profit is our goal whether we are bullish, bearish, or neutral.
2. Based on several studies by the tastytrade research team it has been shown that 45 days to expiration (DTE) is the optimal period in which to get the highest average daily P/L
3. Implied Volatility is the measure of future movements in a particular underlying. Implied Volatility Rank (IVR). IVR tells us the relative level of current IV over the past year. We have discussed in prior posts why we typically look for high IV ranked stocks to sell. High IV implies higher options premium
4. Delta helps us determine the risk profile in a position. It is a metric that tells us the probability of the underlying being above or below the strike price at expiration. Delta measures how the option value will change with a $1 change in the underlying.
In conclusion, we can say that building a trade is a critical element in the overall trading process. And the key factors to consider are:
Directional assumption – Considering the IV environment – Optimal period – Choosing delta in line with your risk preference.