Lesson 6: Creating an options trading plan
The flexibility of options can create many opportunities for an options trader. Learn how to create an options trading plan that works for you.
CIBC Investor's Edge
4-minute read
The flexibility of options can create many opportunities for an options trader. It can also generate an overwhelming number of trading choices.
This is why lessons 3 to 5 focus on understanding a basic strategy — like buying calls or puts — as a simple place to start. These trades allow you to commit a smaller amount of money, and you can begin to understand the price fluctuations your option position will undergo in real time. You’ll get a sense of how your option reacts to changes in the price of the underlying security, the passage of time and possibly to changes in volatility, if that occurs during the lifespan of your trade.
As you select an options trade, here are some of the things you can think about:
Which underlying stock should I choose?
Stocks with greater volatility are frequent candidates for options buyers, who might consult lists of greatest % movers or highest volatility stocks on various exchanges. Other traders might consider the most active stocks or stocks in an industry group that the trader holds an opinion about. Remember though that volatile stocks will almost certainly have a higher volatility premium built into their option prices. This could make a profitable option trade more difficult to achieve.
Which strike price to choose?
Let’s revisit the terms "in-the-money” and “out-of-the-money.”
For call options:
- In-the-money call options — the strike price is below the current market price of the underlying asset.
- At-the-money call options — the strike price is equal to the current market price of the underlying asset.
- Out-of-the-money call options — the strike price is above the current market price of the underlying asset.
For put options:
- In-the-money put options — the strike price is above the current market price of the underlying asset.
- At-the-money put options — the strike price is equal to the current market price of the underlying asset.
- Out-of-the-money put options — the strike price is below the current market price of the underlying asset.
Option strike prices that are in-the-money or not far out-of-the-money have a greater chance of holding some or all their value, as the option is more likely to close in-the-money at expiry. However, they will be more expensive than far out-of-the-money options. Ultimately, of course, the option’s price at expiry will depend on what happens with the price of the underlying stock.
Conversely, farther out-of-the-money options, higher strike prices for calls and lower strike prices for puts, will be cheaper but less likely to close in-the-money at expiry. Further-out strike prices may not respond to moves in the underlying stock when expiry is close, as traders factor in the idea that these options will likely not close in-the-money. For more details, review lesson 3.
Which exercise date to choose?
Longer expiration dates are typically more expensive, as they provide more time for the underlying asset to move in the desired direction.
As we mentioned in lesson 2, the time value portion of the option price will be higher for longer-dated options as compared to shorter-dated options. This is a double-edged sword for option buyers, who benefit from the longer time period for the stock to move in their favour, but must pay a higher option price for that benefit. Also, although time value erodes at a slower pace when the option is further from expiry, it still erodes.
It often makes sense to choose a combination of underlying stock, expiry date and strike price where there is good daily volume, a fair amount of open interest and a relatively small bid-ask spread. Here you want adequate liquidity so you can trade in and out of your position when you choose and at a reasonable price. A word of caution though about those times when equity markets or an individual equity become very volatile. Liquidity often becomes challenging, and the bid-ask spread on your trade may widen substantially even if your position was previously quite liquid.
Remember that option trades can play out quickly
As we mentioned in lesson 5, some option trades will show large percentage gains or losses within minutes of entering the trade. You may need to stay close to your quote screen to minimize your risk of losses or ensure that you exit your trade with your profit intact. Whether or not to enter a sell order at a specified price once you have an open option position is a decision that you’ll need to consider for each trade.
In any case, having a mental target for where you would take your profit or cut your losses is a prudent move. Remember that you’re free to sell your option before expiry if you choose. At expiry, if your option is not in-the-money, it will expire with no value and you will lose 100% of your original investment, plus commission.
Create a plan, revise if necessary
There are no straightforward answers to most decisions when you create an options trading plan. However, thinking about the points mentioned here can start you formulating a trading plan — one that matches your strategy, goals and your understanding of market movements.
Here are some other details that you should know about options. You can refer back to them later, if necessary, when you start to trade options.
- Equity option strike prices are usually listed in increments of $0.50, $1.00, $2.50, $5.00 or $10.00, depending on their price level.
- Adjustments to an equity option contract's size, deliverable (i.e., the underlying stock) and strike price may be made to account for stock splits or mergers.
- Generally, at any given time, equity options are available with at least four future monthly expiration dates. For most stocks and indexes, many more dates are available, which may include daily or weekly expirations.
- Equity option holders don’t enjoy all the same rights as stockholders. Some examples include voting rights, regular cash or special dividends.
