The 10 Keys to Successful Stock Options Trading – Key #3
This week we will discuss the how to choose the underlying stock to trade the options on and the right option to trade on that stock. The first thing to do is perform some fundamental analysis on the underlying stock to make sure you are getting into a stock that is likely to go in the direction you think it will. Check the following items in particular:
(1) The company financials, especially the P/E ratio. The P/E or Price to Earnings ratio is the stock price divided by the earnings per share and is a good indication of the strength of the company. The average P/E over the S&P 500 is about 15 but it varies from industry to industry so check the average for the industry the stock is in. Generally a high P/E indicates a company with strong earnings and growth potential.
(2) The amount of cash the company has on hand, the amount of debt they have and the gross profit margin (defined as the gross profit divided by total revenue). These indicate the company's stability and profitability. Ideally a strong company will have a lot of cash, low debt and a high gross profit margin.
(3) Any relevant news at the online services mentioned in my last article. Check to see if earnings are being announced, if there are any splits coming up or if there is any other economic or company specific news that may affect the stock price Look for particular signs of strength if you are trading calls or weakness if you are trading puts.
Also check the industry the company is in to see how the entire industry is performing. Once you have picked a stock that you think will move either up or down then you need to look at the options chain to see what options are available on that stock.
The options chain displays the expiration date, the strike (or exercise) price, the bid and ask price, the daily volume traded and open interest (the number of options contracts that exist). Let's look at each component in turn.
When choosing the correct option to trade, consider in particular the time until expiration. You never want to hold onto an option that has less than 30 days until expiration because options get cheaper as time goes on and during the last 30 days time decay (as it is called) speeds up. Therefore buy an option with at least 60 to 90 days until expiration.
Consider also how much intrinsic value the option has (defined as the difference between the strike price of the option and the underlying stock price). You should ideally buy an option that has a similar strike price and underlying stock price or one that has a slightly positive intrinsic value.
The difference between the bid and ask price is called the spread. If you place a market order you will pay the ask price if buying or you will receive the bid price if selling. If you don't want to pay the market price you can place a limit order somewhere between the bid and the ask price but be aware that if the price of the option moves away from your limit, your order will not get filled.
The daily volume traded need not be a major concern but the open interest should be at least 100 contracts so that when it's time to sell your option you know there will be plenty of buyers.
One last consideration when deciding what option to buy is the delta of the option. The Delta is one of five so called "Greeks" which refer to the components of how an option is priced. The Delta is the most relevant of the Greeks and indicates how much the option price will change for every $1 movement in the underlying stock price. For instance if you buy a call option in XYZ Company that has a Delta of 0.65 then each time the share price of XYZ moves up a dollar your option will increase $0.65 in value. Obviously the higher the Delta the better it is for you but options with a higher Delta tend to cost more to purchase.
Stay tuned for Key #4 when we will look at how to decide when to place your trade and how to identify a good entry point.
US Government required disclaimer: Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of the Characteristics and Risks of Standardized Options. Copies of this document may be obtained from your broker, from any exchange on which options are traded or by contacting The Options Clearing Corporation, One North Wacker Dr., Suite 500 Chicago, IL 60606 (1-800-678-4667).
Roger Cox was born in New Zealand and has lived in Los Angeles for seven years. He was President of a freight company at LAX before setting up his own consulting firm. Roger has successfully traded stock options for over 4 years and teaches other people how to successfully trade at http://www.prosperitywithoptions.com
(1) The company financials, especially the P/E ratio. The P/E or Price to Earnings ratio is the stock price divided by the earnings per share and is a good indication of the strength of the company. The average P/E over the S&P 500 is about 15 but it varies from industry to industry so check the average for the industry the stock is in. Generally a high P/E indicates a company with strong earnings and growth potential.
(2) The amount of cash the company has on hand, the amount of debt they have and the gross profit margin (defined as the gross profit divided by total revenue). These indicate the company's stability and profitability. Ideally a strong company will have a lot of cash, low debt and a high gross profit margin.
(3) Any relevant news at the online services mentioned in my last article. Check to see if earnings are being announced, if there are any splits coming up or if there is any other economic or company specific news that may affect the stock price Look for particular signs of strength if you are trading calls or weakness if you are trading puts.
Also check the industry the company is in to see how the entire industry is performing. Once you have picked a stock that you think will move either up or down then you need to look at the options chain to see what options are available on that stock.
The options chain displays the expiration date, the strike (or exercise) price, the bid and ask price, the daily volume traded and open interest (the number of options contracts that exist). Let's look at each component in turn.
When choosing the correct option to trade, consider in particular the time until expiration. You never want to hold onto an option that has less than 30 days until expiration because options get cheaper as time goes on and during the last 30 days time decay (as it is called) speeds up. Therefore buy an option with at least 60 to 90 days until expiration.
Consider also how much intrinsic value the option has (defined as the difference between the strike price of the option and the underlying stock price). You should ideally buy an option that has a similar strike price and underlying stock price or one that has a slightly positive intrinsic value.
The difference between the bid and ask price is called the spread. If you place a market order you will pay the ask price if buying or you will receive the bid price if selling. If you don't want to pay the market price you can place a limit order somewhere between the bid and the ask price but be aware that if the price of the option moves away from your limit, your order will not get filled.
The daily volume traded need not be a major concern but the open interest should be at least 100 contracts so that when it's time to sell your option you know there will be plenty of buyers.
One last consideration when deciding what option to buy is the delta of the option. The Delta is one of five so called "Greeks" which refer to the components of how an option is priced. The Delta is the most relevant of the Greeks and indicates how much the option price will change for every $1 movement in the underlying stock price. For instance if you buy a call option in XYZ Company that has a Delta of 0.65 then each time the share price of XYZ moves up a dollar your option will increase $0.65 in value. Obviously the higher the Delta the better it is for you but options with a higher Delta tend to cost more to purchase.
Stay tuned for Key #4 when we will look at how to decide when to place your trade and how to identify a good entry point.
US Government required disclaimer: Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of the Characteristics and Risks of Standardized Options. Copies of this document may be obtained from your broker, from any exchange on which options are traded or by contacting The Options Clearing Corporation, One North Wacker Dr., Suite 500 Chicago, IL 60606 (1-800-678-4667).
Roger Cox was born in New Zealand and has lived in Los Angeles for seven years. He was President of a freight company at LAX before setting up his own consulting firm. Roger has successfully traded stock options for over 4 years and teaches other people how to successfully trade at http://www.prosperitywithoptions.com
