How to do Homework for Options Trading Success

by Jeffrey Lin

My notes from Hamzei Analytics' "Trade Options like a DPM: Class #8 Ratio Spreads".

Mechanics of options is the same whether the option you're trading is stock options, futures options, bond options, or forex options. What options do depend on the financial instrument underlying the option (i.e. individual stock, ETF, stock indexes, futures contracts, forex, bonds, etc). Therefore, it is important to have a good feel and understanding of the underlying financial instrument. We'll explain with stocks. This means, but not limited to:

1. Understand what factors affect a particular stock the most.
2. Understand where the important price levels are for each stock you may trade
3. What do you expect the stock to do at those price levels: breakout, breakdown, bounce, fall, pause then continue, or move sideways?
4. How do you expect the stock to act? Slow and steady like many blue chip stocks? Fast and smooth like Apple? Fast and volatile like many smallcap stocks? Some people refer to what they trade as a "trading vehicle." So, if a stock were a car, how do you expect it to drive? Like a truck, van, sedan, or sports car?
5. What might the stock do and go during a specific time frame? Options are time dependent, and decay until it is either in-the-money or worthless at expiration. So the stock must do what you expect within a certain time frame (i.e. before expiration) for you to have a chance to be profitable.

Hint: #2-5 can often be determined through detailed, experienced chart analysis.

Options can be fairly simple and amazingly complex. There are

• 2 basic option types: calls and puts.
• 4 ways to trade these: buy calls, sell (short) calls, buy puts, sell (short) puts.
• 6 options variables (a.k.a. Options Greeks) that options depend on: stock price, delta, gamma, vega, theta, and rho.

With so many possible combinations, there are essentially unlimited option strategies you can design to trade any move a stock can make. So, thoroughly understand each strategy and its nuances.

1. From your stock analysis (or analysis of the underlying financial instrument), look at pricing models to know "why am i going to create this strategy."

2. Of the option strategies you know, which options strategy should you implement? This depends on

• the particular stock
• the particular time
• what the overall market is doing
• the overall market tone
• where the stock's volatility is: what is the implied volatility doing vs. the historical volatility?

3. Understand and KNOW how to successfully trade each strategy from both the buy side and sell side.

4. Understand how each strategy reacts, moves, and changes with every move and price level for the stock. The 3 different option “moneyness,” i.e. in-the-money options, at-the-money options, and out-of-the-money options behave quite differently.

5. Once you know your option strategies inside and out, know how to adjust an options trade if the stock does not behave as you expected, your risk increases, and when you lose on the trade. That means also knowing how to morph one strategy into another. Remember, option strategies are built from several building blocks, so rearranging them in a methodological way would change one strategy into another.

*hint: For #3-5, innovations by online options brokers such as tradeMONSTER's Snapshot Analysis, spreadMAKER, and adjustTRADE helps you simulate the various scenarios.

1. Have a watchlist of stocks you are comfortable and prepared to trade, as discussed in the first section. Find within that list which stocks match certain criteria for successful options trade.
2. Understand where the volatility levels are specific to that stock. Where is volatility cheap (under historical) where you want to buy volatilty, and where volatility is expensive (over historical) so you sell volatility.
3. Have a gameplan. Play out the various scenarios of what the stock may do and what volatility may do. With that in mind, figure out how the particular option strategy you’ve chosen would react, and your backup plans so you know exactly what to do when things go right and when things go wrong.
4. Check the environment for your watchlist and individual stocks you’re doing options trades:

• Earnings
• Company news
• Sector news and seasonlaity
• Time period in market