Every trader must consider The Top 4 Trade Metrics before making a trade.
Today we will look at the top 4 trade metrics and show how to use them in building a trade
These metrics are firmly rooted in math and solid research.
The Top 4 Trade Metrics
Liquidity
Liquidity is by far the most important metric for every trade. I use the Tastyworks Trading Platform to place my trades. They use a four-star ranking system to indicate the degree of liquidity for each underlying. We want to see high volume in both the options and the underlying security. In addition, we want to see a narrow spread between the bid and the ask price for the individual option strikes. The greater the degree of liquidity, the more a trader can be confident that the prices they are paying/receiving for a particular contract are fair
IV Rank
At any point in time an options trader must determine if he/she is going to be a buyer or a seller. IV Rank guides the trader in this decision-making process. When IV rank is high (above 25%) we will look to sell options for credit. If the IV Rank is below 15%, then we look to buy an option for a debit. Approximately 80% of the stocks I trade have Rank well above 30%.
Delta
The delta value determines direction and probability. For a 16 delta option the probability of the option being out of the money at expiration is 84% (100 – 16 = 84%). Delta also gives us a measure of directional risk. We are looking to determine how much risk we are taking in relation to the S&P 500 index. It’s up to each individual trader to determine how much risk to take. If your total portfolio has a positive delta, then it will profit from a positive move in the S&P.
A plus 40 deltas is equivalent to owning 40 long shares of SPY. If the SPY goes up $1, the portfolio will go up by $40 (approximately).
Duration
The last metric is duration. We aim for a trade duration of between 30 and 45 days to expiration (DTE). We do this because this time frame maximizes time decay (theta) relative to risk (Gamma). Gamma is a measure of risk of an option that measures the amount by which the delta changes for a 1 point change in the price of the stock. The gamma risk in a position is 5x higher for shorter duration trades than longer ones. We are trying to find where on this durational curve is the sweet spot.
Applying these calculated metrics when trading options allows for a mechanical and consistent game plan. We need to consider all of these metrics before sending an order.
