This week we will discuss the how to choose the underlying
stock to trade the options on and the right option to trade
on that stock. The first thing to do is perform some
fundamental analysis on the underlying stock to make sure
you are getting into a stock that is likely to go in the
direction you think it will. Check the following items in
particular:
(1) The company financials, especially the P/E ratio. The
P/E or Price to Earnings ratio is the stock price divided
by the earnings per share and is a good indication of the
strength of the company. The average P/E over the S&P 500
is about 15 but it varies from industry to industry so
check the average for the industry the stock is in.
Generally a high P/E indicates a company with strong
earnings and growth potential.
(2) The amount of cash the company has on hand, the amount
of debt they have and the gross profit margin (defined as
the gross profit divided by total revenue). These indicate
the company's stability and profitability. Ideally a strong
company will have a lot of cash, low debt and a high gross
profit margin.
(3) Any relevant news at the online services mentioned in
my last article. Check to see if earnings are being
announced, if there are any splits coming up or if there is
any other economic or company specific news that may affect
the stock price Look for particular signs of strength if
you are trading calls or weakness if you are trading puts.
Also check the industry the company is in to see how the
entire industry is performing. Once you have picked a stock
that you think will move either up or down then you need to
look at the options chain to see what options are available
on that stock.
The options chain displays the expiration date, the strike
(or exercise) price, the bid and ask price, the daily
volume traded and open interest (the number of options
contracts that exist). Let's look at each component in turn.
When choosing the correct option to trade, consider in
particular the time until expiration. You never want to
hold onto an option that has less than 30 days until
expiration because options get cheaper as time goes on and
during the last 30 days time decay (as it is called) speeds
up. Therefore buy an option with at least 60 to 90 days
until expiration.
Consider also how much intrinsic value the option has
(defined as the difference between the strike price of the
option and the underlying stock price). You should ideally
buy an option that has a similar strike price and
underlying stock price or one that has a slightly positive
intrinsic value.
The difference between the bid and ask price is called the
spread. If you place a market order you will pay the ask
price if buying or you will receive the bid price if
selling. If you don't want to pay the market price you can
place a limit order somewhere between the bid and the ask
price but be aware that if the price of the option moves
away from your limit, your order will not get filled.
The daily volume traded need not be a major concern but the
open interest should be at least 100 contracts so that when
it's time to sell your option you know there will be plenty
of buyers.
One last consideration when deciding what option to buy is
the delta of the option. The Delta is one of five so called
"Greeks" which refer to the components of how an option is
priced. The Delta is the most relevant of the Greeks and
indicates how much the option price will change for every
$1 movement in the underlying stock price. For instance if
you buy a call option in XYZ Company that has a Delta of
0.65 then each time the share price of XYZ moves up a
dollar your option will increase $0.65 in value. Obviously
the higher the Delta the better it is for you but options
with a higher Delta tend to cost more to purchase.
Stay tuned for Key #4 when we will look at how to decide
when to place your trade and how to identify a good entry
point.
US Government required disclaimer: Options involve risk and
are not suitable for all investors. Prior to buying or
selling an option, a person must receive a copy of the
Characteristics and Risks of Standardized Options. Copies
of this document may be obtained from your broker, from any
exchange on which options are traded or by contacting The
Options Clearing Corporation, One North Wacker Dr., Suite
500 Chicago, IL 60606 (1-800-678-4667).
----------------------------------------------------
Roger Cox was born in New Zealand and has lived in Los
Angeles for seven years. He was President of a freight
company at LAX before setting up his own consulting firm.
Roger has successfully traded stock options for over 4
years and teaches other people how to successfully trade at
http://www.prosperitywithoptions.com
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