The most common question I get from Cabot Options Traders and traders that I coach is “How do I choose which option to buy?” I totally understand the confusion. If you want to buy a call or put, and open your brokerage account there are seemingly an endless amount of expirations and strike prices to choose from. It can be overwhelming! However, in this article, I hope to eliminate a lot of that noise so that you can more confidently trade options.
Below I am going to break down my general thought process and style using these two categories:
1. Which option expiration should I buy?
2. Which strike price should I buy?
Which Option Expiration Should I Buy
Knowing your trading strengths and weakness is critical to long term trading success. And while my market timing is not necessarily a weakness, I do know that I am NOT one of the handful of traders in the world who can consistently buy the bottoms and sell the tops in stocks. And even those handful of traders can probably only do that five out of every 10 trades.
However, I do know that I am great at finding good looking stocks, and then executing good risk/reward options trades that over a longer time frame will do very well.
And because I know timing the market in the short term is incredibly difficult I NEVER buy options that are expiring in three weeks or less. Why? Because those options, while inexpensive and very enticing, are going to decay/lose value at a rapid rate as time is running out on them. Also, a bad day or two for the market or that stock could cripple the likelihood of the trade’s success.
However, if I give myself five to seven months for a trade to work the odds of success rise as a market that is wobbling for a day or week, but then recovers, won’t dramatically hurt this longer-term position. Also, because there is so much time until the trade expires, the option decay is minimal.
So for example, with this being the first week of July, I would not buy an option in the July expiration as these calls/puts only have two more weeks before they cease to exist.
Similarly, I will likely avoid buying options expiring in August and September as those months are too close till expiration for my comfort.
Moving on until October expiration I have growing interest … and then by November through January of 2020 I think are the sweet spots for option buys.
In essence, I have found my sweet spot for buying options is between five and seven months until their expiration.
Which Strike Price Should I Buy?
Once you have chosen the expiration cycle to target the next step is determining which strike price to buy. The way I look at this is in terms of odds.
For example, what are the odds that slow and steady stock ABC will rise $10 in the next five months? Not very good … so I would eliminate calls that are $10 or more out-of-the-money and instead focus on calls that are at-the-money or just slightly out-of-the-money.
But what if instead of slow stock ABC, I’m evaluating the odds that fast-moving stock XYZ will rise those same $10 in five months. I think those odds are more likely, so I’m willing to target a call $10 out-of-the-money in that situation.
With this in mind, I typically only buy calls that I think have a better than 40% chance of finishing-in-the-money. These are calls that are at-the-money, or just slightly out-of-the-money.
For example, if stock YYY is trading at 100, I would target the 100 strike call which is at-the-money, or the 105 call that is slightly out-of-the-money. However, I would never target the 120 strike or above as I don’t believe the odds of the stock rising well above 120 are great.
The other reason I typically buy calls that are close to the current stock price is those calls will move aggressively as the stock rises. Conversely, calls that are far out-of-the-money won’t move much unless the stock makes a dramatic move higher.
Conclusion
I’m sure there are more aggressive traders who wholeheartedly disagree with everything I wrote above and prefer to buy weekly options that are out-of-the-money. However, at the end of the day, I think those strategies are a massive mistake, and I prefer to put the odds of success in my favor … and I have found that buying calls/puts that are at-the-money to slightly out-of-the-money with five to nine months until their expiration is my favorite strategy.