Trading in securities at a pre-determined price, whether buying or selling, is preferred by many because trading in options provide good money-making opportunities. Options are derivative contracts that come with conditions attached that allow the holders of the contract to buy or sell it at a chosen price. Options sellers carry more risks than option buyers which is why they demand a premium from buyers. However, in case of prices are not favorable, sellers can protect their interests by allowing the option to expire so that the losses do not exceed the premium.
Options have been around for more than 45 years, having made its first appearance in 1973, but failed to attract investors as most felt it was tough to understand and were just too much sophisticated. Indeed, options are something new in derivative trading and need proper knowledge and training to deal with it. Unfortunately, many investors and traders burned their fingers in experimenting with it without proper preparation and incurred losses. This made many people averse to options. However, options trading can do much good for investors, and in this article, we will discuss how to choose the right options.
Have an objective
The option is just like any other investment, and you must create an investment objective first before you being the journey. Decide what you want to achieve by trading in options. It could range from speculating about a bearish or bullish view of the asset in question to hedging the risk of losing out on a stock that occupies a significant position in your portfolio. Even if you are trying to earn premium income from trading, it might be one of your objectives.
Work out the risk vs. reward payoff
Where you want to put yourself in the risk-reward payoff ladder is a matter that you must decide by considering your risk tolerance level or how much risk you are ready to take. It is linked to the option strategy that you adopt subsequently by referring to Phil’s stock world option trading strategies pdf by aligning it to your risk and reward profile. For example, buying a large amount of deep out of money (OTM) is a very aggressive strategy that does not suit conservative investors.
Gauge the implied volatility
Option price depends on implied volatility that indicates whether other traders are expecting considerable movement of the stock. High implied volatility pushes up premiums meaning that writing an option is attractive provided the volatility does not increase. Conversely, cheaper options come with low implied volatility that indicates it is time to buy options.
Have an eye on events
Try to identify events that you might experience during your journey in options trading because it would impact the markets. Events like the Federal Reserve increasing interest rate will have a negative impact on the market, and the same can happen if events are stock specific like product launches.
After you have analyzed your investment profile by vetting it against the above factors, you can move towards creating option strategies. The strategies would be cut out according to your traits as an investor.
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