ANATOMY OF AN OPTION TRADE - FUNDAMENTALS OF SELLING RISK-DEFINED OPTIONS
Anatomy of an Option Trade:
Below is a step-by-step guide for long-term options success when applying defined criteria (10 Option Trading Rules) on a consistent basis given a high number of trade occurrences. Here, I walk through the trade set-up when selling options premium in the form of a risk-defined put spread.
Liquidity in the options market, ability to stagger expiration dates, sector diversity, strike width, options delta, high implied volatility rank and potential ROI are some of the key elements I look for when selling options.
Option contracts need to be liquid with ample open interest and volume to yield tight bid and ask spreads. This liquidity ensures optimal option pricing execution when executing trades to open and close option legs.
Staggering Expiration Dates:
Option contracts should be sold in a staggered expiration manner meaning that a small cohort of trades should be expiring every Friday not just the third Friday of each month. This ensures adequate risk spread and avoids expiration density if the market was to move against a large cohort of trades all expiring on the same date.
Exposure to various sectors ensures sector diversity in the options contracts. This will mitigate specific sector exposure and risk.
Strike widths can vary widely however I try to target a range of $200 - $1,000 of risk per contact. Risk per contract should target ~1% but not exceed 3% of the portfolio value.
Options delta servers as a proxy for probability of success at expiration. This is an absolute number so a value of -0.15 on the put side option chain is 15% or an 85% probability (1.0 - 0.15) that the underlying stock will expire worthless at expiration. I target the ~0.15 delta area when selling options.
High Implied Volatility (IV) Rank:
IV Rank is the current IV value compared to its previous 52-week volatility range. This is a measure of how the current value "ranks" in relation to its historic volatility range.
A high ranking translates into the fact that its current value ranks high relative to its historic range, indicating that investors expect a big move in the underlying stock. This high IV Rank gives option contracts rich value and provides option traders with an edge since IV rank is nearly always overestimated and the stock will not be as volatile as predicted by its current high IV rank.
ROI Per Trade:
Targeting 5-15% ROI per trade is reasonable so if there's a strike width of $500 and the premium received was $50 then the required capital is $450 per contract. The potential ROI at expiration if the option expires worthless would translate into $50/$450 = 11.1% ROI.
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