The best way to Learn to trade Options is no more difficult than learning to do about anything else.
We need some basic understanding of the tools and materials we are going to need and some directions about how to proceed.
The difficulty comes from the perception of risk and what we have heard from those who are supposedly “in the know”.
We’ve heard that you can lose all your money and only certain people can understand how options work. Big words like, hedge fund manager and market makers, and high frequency trading tend to send us running off into a corner and pull a dark blanket over our heads and cower in fear. But none of that is necessary. In this post I am going to show you how simple it is to put on a trade by keeping a few basic ideas in mind.
Options do involve risk. Money can be made and lost. But not all of your money is going to be lost because you aren’t going to trade all of your money. And there is no need to do so. That would be silly and unwise by any measure.
Today I’m going to share with you the steps I took when I set up a trade. I’ll cover the most important metrics I look at and then I’ll cover how I choose a strategy, before I click the send button. Hopefully, you will see that trading options is a fairly straight forward process.
I will be mentioning some factors that will make you a better trader, but for now I am not going to give a full-blown explanation of them. I will cover all these terms in a later post. For now, just know that as you learn more, these terms will make perfect sense. So, let’s get trading.
The Learn to Trade Checklist
The main driver in my decision-making process is IVR. IVR stands for Implied Volatility Rank. IV is a measure of the future movement in a given stock. IVR tells us where the implied volatility of the underlying is relative to the past twelve months. Since IV is mean reverting over time, we can use IVR to tell us, if the IV is high or low. High IV tends to move down and low IV tends to move higher.
Implied Volatility has a direct relationship to perceived risk in the underlying and whether the price of an option is high or low. IV has an inverse relation to price. A low IV often corresponds with an elevated price of the underlying. Whereas a high IV is often associated with a price making lows. Now, since IV is mean reverting, and if the IV is high, we can say that the stock has been trending lower. And may be getting ready for a rise in price. We tend to buy options when IVR is low and sell options when IVR is high
Volume, open interest, and liquidity are the other important factors to consider before putting on the trade.
Planning a trade
So, let’s say that XYZ has a high IVR (IV is in the high end of its range). There is an expectation of a large movement in the price of XYZ. Earnings may be coming up and uncertainty about the future movement of the price is building. Volume is high with good open interest over a range of strike prices. Looking at the options prices for the 30 delta puts and calls we see that the bid/ask spread is very narrow – let’s say $.01 wide. This is a very liquid opti
So my first impression is favorable for XYZ.
Since XYZ has a high IVR, and the stock is at its all time low I may assume that XYZ could be in for a move upwards.
MY directional bias is bullish. If XYZ were trading for $75.00, and high IVR I am looking for the stock to rise in price.
One quite common strategy in this scenario is the short put vertical spread. This involves selling an out of the money (OTM) Put option and simultaneously buying a further OTM put option to define the risk to the downside. This is a bullish strategy with defined risk. I receive a credit, when I put on this spread. If the price goes up as I hoped, and the price is above the short strike at expiration, the spread will be trading out of the money, and I get to keep the credit. If my spread had been $5 wide and I received 1/3 the width of the strikes (about $1.65) my risk is defined to a loss of $5 minus the credit received (1.65). My max loss is $3.35 ($335.00).
IVR is high, volume and open interest are favorable, liquidity is optimal, and my directional bias is bullish. Max Profit equals the credit received for the trade. The breakeven point is the short strike minus the credit received. Other strategies could be employed with a similar directional bias and we will consider the possibilities in a later post. I hope you can see that this isn’t scary stuff. There are other considerations when putting on such a trade as the one mentioned, but the mechanics are simple and nothing to lose any sleep over. Know your risk, trade small and be mechanical. Options give you Options.
If you have any questions about this post, please leave a comment below and I will get back to you as soon as I can.