Disclaimer – This example was selected for the demonstration provided below. These trade setups happen all the time and on every chart but your results may vary. You should always do your own due diligence before making investment decisions and/or consult a registered financial advisor. This page is not a recommendation for you to buy or sell any securities or attempt the information provided. It is for education and entertainment purposes only.
Selecting an Options Trade the Easy Way
On the previous page I walked through a simple assessment of Delta’s stock chart. I was able to conclude or at least confidently decide that Delta’s stock price would move higher.
To place a trade via TD Ameritrade’s ThinkorSwim platform follow along… There are many brokers to choose from but I believe TD Ameritrade is the best! I wont cover them here but don’t worry, they’ll be discussed thoroughly in another section of this site.
– Determine the expiration time frame
– Determine the strategy
– Determine amount of capital to risk
– Determine the strike price(s)
– Determine a Profit target
– Determine a loss target
These steps are a simplified version of a trading plan. Most traders fail because they don’t follow their plan throughout the entire trade. Once its determined, it’s set in stone! DON’T be the person that holds on to a losing position past your loss target with the hope it will rebound. If an adjustment is necessary. Make it. If not, close the position and move on. I’ll talk more about adjustments in the different strategies.
Step 1. Determine the Expiration time Frame
Unfortunately there is no hard, fast rule when applied to expiration time frames. I try and determine how quickly I anticipate the move. I’m sure others will have a different method for deciding their expiration month and that’s fine. But for the sake of simplicity and the sake of introduction I’ll select an expiration based on how quickly I expect the move.
If this explanation doesn’t quite do it for you. Take a look at this article on Dough.com, they are a great resource!
For this example… I believe the move will happen in the near future.
Decision: March 2016 expiration month. 31 days until expiration.
Image Below. Click to Enlarge.
Step 2. Determine the Strategy
To keep things simple for this example I’ll be selecting a long call position. Strategies will be discussed in depth in another section but as a primer, a long call is the purchase (debit) of a call option contract. The anticipation is that the stock will move higher and thus, the option contract will increase in price.
WARNING – Volatility and time decay can cripple a long single option strategy. Both will be discussed in the relevant strategy pages.
Decision: Buy a Call Option.
Step 3. Determine Risk Capital
How much money do I want on the line? After all, this position could go against my assumption…
As a general rule I usually allocate 2% of my available capital to any one trade. For this example I’ll assume I have a trading account with $5,000 available to trade. This falls under money management techniques and for a great article on money management take a look at swing-trade-stocks.com, they have some great information about stock trading!
So 2% of $5,000 = $5,000 x .02 = $100.00 of capital to risk
Decision: $100 max risk
Step 4. Determine the Strike Price
Choosing the right strike price can be the difference in success or failure and unfortunately there isn’t a stable rule that can be applied in all circumstances. It’s more of an art than a science. Or maybe its both… I digress…
For this example I’m assuming a quick move higher in the share price of Delta. Good practice when selecting long options is to select a contract at or above a 75 delta. I won’t be covering the greeks in this exercise but just be aware the best strike price to select in this instance would be the one with a higher delta.
Unfortunately our 2% allocation of capital doesn’t get us in the ballpark of the strike with a 75 or better delta. I’ll have to make a concession. Do I want to increase the amount of capital at risk with the hope of a larger reward (and larger loss)? or do I simply want to select a strike that falls under my $100 of max risk?
For this example, and what I feel is good practice in general is to err on the side of caution and choose the option that protects my money.
I’ll choose a strike that is as close to at the money (ATM) as possible while still under my $100 of allowed risk.
Decision: March 2016 $47 call option
Image below. Click to enlarge.
Step 5. Profit Target
Long options have the unique characteristic of unlimited reward. In that light I’ll choose not to set a firm profit target. I’ll monitor the position daily and close when I feel the move has ended.
Decision: Let winners run, close if research suggests the trade will move against me.
Step 6. Loss Target
It is imperative that a loss target be set prior to entering a position. Once a position is opened emotions begin to wreck havoc on the ability to make logical decisions. Set a loss target and STICK TO IT! If the position moves against expectations, close it and move on.
For this example we’ve selected the March 2016 $47 call.
This option contract is currently trading for $.97 cents or $97 because 1 option contract gives us the right to buy 100 shares of stock at the strike price of $47.
For this example I’m willing to risk only 20% of my $100 of allocated capital.
$100 x .20 = $20
$97 – $20 = $77 or $.77 cents
If the position moves against me my max loss will be $20.
Decision: Close if March $47 call is trading at or below $.77 cents.
Let’s recap the decisions I’ve made for this example…
– March 2016 expiration month. 31 days until expiration.
– Buy a Call Option.
– $100 max risk.
– March 2016 $47 call option
– Let winners run, close if research suggests the trade will move against me.
– Close if March $47 call is trading at or below $.77 cents.
With every decision made… I just have to physically send my trade…
Sounds easy enough… right?
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