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Option Trading Tips

As an option buyer, your objective should be to purchase options with the longest possible expiration, to give your trade time to work out. Conversely, when you are writing options, go for the shortest possible expiration to limit your liability. 

Trying to balance the point above, when buying options, purchasing the cheapest possible ones may improve your chances of a profitable trade. The implied volatility of such cheap options is likely to be quite low, and while this suggests that the odds of a successful trade are minimal, the option may be underpriced. So, if the trade does work out, the potential profit can be huge. 

Buying options with a lower level of implied volatility may be preferable to buying those with a very high level of implied volatility, because of the risk of a higher loss (higher premium paid) if the trade does not work out. There is a trade-off between strike prices and options expirations, as the earlier example demonstrated. 

An analysis of support and resistance levels, as well as key upcoming events (such as an earnings release), is useful in determining which strike price and expiration to use. Understand the sector to which the stock belongs. 

For example, biotech stocks often trade with binary outcomes when clinical trial results of a major drug are announced. Deeply out-of-the-money calls or puts can be purchased to trade on these outcomes, depending on whether one is bullish or bearish on the stock.

 It would be extremely risky to write calls or puts on biotech stocks around such events unless the level of implied volatility is so high that the premium income earned compensates for this risk. By the same token, it makes little sense to buy deeply out of the money calls or puts on low-volatility sectors like utilities and telecoms. 

Use options to trade one-off events such as corporate restructurings and spin-offs, and recurring events like earnings releases. Stocks can exhibit very volatile behavior around such events, allowing the savvy options trader an opportunity to cash in. 

For instance, buying cheap out-of-the-money calls before the earnings report on a stock that has been in a pronounced slump, can be a profitable strategy if it manages to beat lowered expectations and subsequently surges.

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