A crucial part of options trading is understanding how to read an option chain to select the right contract for your trade idea. Even if your trading thesis is correct, selecting the wrong option contract can still result in a losing trade. Once you have your trade idea, there are 4 steps that, if followed properly, will result in the selection of the perfect options contract for your trade idea to maximize profits. The 4 steps in selecting an options contract that best fits your trade idea are:
We will be breaking down how to properly execute each of these steps.
First, we need to clarify the difference between a trade idea and a trade thesis. A trade idea is simply a potential trade opportunity that you have identified. This is the very first step toward executing a profitable trade. However, once you have your trade idea, you need to to test a couple aspects of the trade idea to confirm or validate there is genuine opportunity. This is your trading thesis. The best way to determine if a trade idea presents genuine opportunity is by calculating the potential risk and reward. Let's use $ROKU as an example.
In this trading thesis we're looking at $ROKU to the downside. The stock just closed below the 20 day SMA, a level it has struggled to hold onto during the current 8 month downtrend. Prior to recent consolidation, in all 8 trading sessions that $ROKU crossed and closed below the 20 day SMA, it moved lower the following trading session. With historical validation $ROKU has downside potential with a close below the 20 day SMA, we determined a break below $117.50 (recent lows of consolidation phase) would be the best confirmation indicator to enter a bearish position.
Now that we have our trade idea, we must determine the potential risk and reward based on our target entry. Since the 20 day SMA has acted as a key level, it would be wise to cut losses if $ROKU crossed back above the 20 day SMA, currently sitting at $126. This gives us an $8.50 risk from our entry price of $117.50. Our potential reward was based on the belief a break below recent consolidation should have the strength to make lower lows within the 8 month downtrend, a price of $98. This gives us a potential max reward of $19.50. Our risk/reward ratio is 2.30/1. Generally you want at least a 2/1 risk/reward ratio, so we feel comfortable that there is enough potential reward in this $ROKU trade idea to warrant the risk.
Next we need to determine what kind of timeframe we are looking for this move to play out within. This part is crucial when considering option contracts lose value over time, also known as theta decay. Using the average true range indicator, we concluded that based on the size of $ROKU's average daily trading range a 1 - 2 week timeline was realistic to allow the move to play out.
There's nothing worse than having an earnings report or market catalyst such as an FOMC meeting completely derail your trade setup. Scanning the news to see if any type of volatility-creating events are scheduled to take place within the timeframe of your trading thesis will save you from the heartache of letting one of these events ruin your trade that you worked so hard for, or at least allow you to be cognizant of the event and prepare accordingly.
Now that we have prepared a solid trade thesis, it's time to take a look at the option chain. The first thing we need to do is narrow down our options by selecting the contract expiration that makes the most sense for our trade thesis. In our sample $ROKU trade thesis we determined it should take 1 - 2 weeks for our trade to play out. With that in mind, it's probably best to select a contract with at least 2-3 week until expiration.
Once we have our ideal contract expiration selected, we need to select the best strike price for our trade thesis. Keep in mind this can be a fluid process as options are constantly changing throughout the trading day. While there may be an ideal contract right now, by the time we reach our target entry price there could be a better strike price option (no pun intended).
While you don't want to pay extra for an ITM option just to increase your exposure if the trade doesn't work out, you also don't want to select a contract that is so far OTM that there is realistically almost no chance it ends up ITM within your trade's timeline. The best way to determine which strike price to select is to find the right balance between cost and value. Usually an OTM contract that would end up comfortably ITM if the potential reward of your trade thesis is reached. Remember, theta rate will increase as your option contract gets closer to expiration, so eventually toward the end of your trade timeline you will need the contract to gain intrinsic value to make up for the lost extrinsic value. Going back to the $ROKU example, a reasonable strike price to select would be $110 puts. This strike price will bring a reasonable cost since it is $7.50 OTM from our entry price of $117.50, while also providing the potential to go $12 ITM if our $98 target price is reached.