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How to Pick, Trade, and Strategise With Stock Options

Options traders want to know which stock options to pick. But before settling on a specific stock, option, strike price, or expiration date, the trader first needs to know what the market sentiment is.

Picking Stock Options and Market Sentiment

The two major types of options are Calls and Puts. If one purchases a Call, he will make money as the market rises. If someone buys a Put, their profits will grow as the market drops. Regardless of whether someone is buying or selling options, they need to be able to determine market direction first.

What are some useful methods for determining market sentiment?

  1. William O’Neil’s CANSLIM method
  2. Using the 50-day moving average
  3. Using the 350-day moving average
  4. Utilising a trend following tools such as the ADX or Aroon

There are a variety of ways to determine the market sentiment. Of course, the preferred method will largely depend on the type of investor. A long term investor that prefers fewer trades will gravitate toward the 350 day moving average technique.

A shorter term investor interested in institutional buying and selling might use the 50-day moving average. Proficient chartists will use the CAN SLIM method while those who prefer technical analysis might use the ADX or Aroon trend following tools.

As a rule:

  • Write Put options in a bull market
  • Write Call options in a bear market
  • Purchase Put options in a bear market
  • Purchase Call options in a bull market

Picking the Appropriate Stock Options Strategy

The next difficult task is to pick the proper type of strategy. The two broad categories are debit and credit trading.

Debit trading means that it costs to take up a position in the market. If one simply purchased an options contract, this is a debit trade.

A credit trade is one where money is made from making a transaction. If someone wrote and sold an options contract, this is a credit trade. Money is instantly made from the transaction.

Simple credit trading is in the form of selling naked options. This is highly risky and should generally be avoided by new traders. Simple debit trading is purchasing options and this too carries high risk since the trader must be proficient at forecasting market direction to make money.

But there are many other types of credit and debit trades as well. This article will focus solely on debit spreads.

Stock Options Debit Trades and Spreads

In addition to the simple purchase of options, these strategies also exist in the debit category.

  1. Long Straddle – this strategy involves buying an ‘at the money’ Put and Call option. If the stock goes up or down a certain amount the purchaser will profit. Volatility is expected.
  2. Long Strangle – this is identical in every way to the long straddle except for one major difference: the Put and Call are ‘out of the money’. This is cheaper to purchase but has proportionately less chance of being profitable. Even higher volatility is expected.
  3. Bull Call Spread – When one buys a Call but sells one further ‘out of the money’, this is a bull call spread. This is done when the expectation is that the market will rise somewhat. The bull call spread lowers cost than that of simply buying a Call.
  4. Bear Put Spread – Similar idea to the Bull Call spread except the expectation is a mild market drop. The trader purchases and ‘at the money’ Put and sells a further ‘out of the money’ Put. This lowers the cost of the Put.
  5. The Condor Spread – This spread involves purchasing two options and selling two options. The written options are slightly above and below the share price. The purchased options are further away on either side. The idea is if the stock moves very little is price, the written options will deflate in value thus leaving the trader with a decent profit. This is a good strategy if one is neutral on direction.
  6. Long Put Butterfly – This is another strategy for a neutral market that has the highest profit if the stock price remains stable.
  7. Collar Strategy – This is for asset holders such as those who purchase shares. They can write Call options on the stock they own while purchasing Puts at the same time to protect against a loss.

Picking the Right Stock Options

The next part is simple. Once a trader knows the direction of the stock market and the strategy he wishes to employ, he needs to find the proper stocks with options to trade. Merely go to a screener such as this one.

If the strategy involves large price moves – select optionable stocks with high volatility.

If the strategy is a neutral one that profits from stocks remaining motionless – select optionable stocks with low volatility.

No doubt a trader would first look at a stock chart of the highly volatile stock to ensure it is trading in the desired direction.

The Complete Stock Options Trading Strategy

Of course, nothing is fool-proof in today’s market. There are all sorts of unexpected surprises that the economy throws at investors globally. But having a strategy, knowing market sentiment, and picking the appropriate stock options is one way to increase the odds of success.

About the author

Louis Charlton

Hi, I'm Louis! I am a home-based part time trader who has built up knowledge of the stock market in my spare time (whilst drinking a lot of coffee). I hope to pass on some of my knowledge to others who want to start in this field.

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