The Right Option Strategy

As an options trader, we can play the market any way that we want. We can trade index options, options on bonds, options on futures, and general stock options on companies. In this article, we are going to dive into a simplistic, yet effective, way to choose a particular option strategy with a live position.

Generally speaking, most traders have a strategy in mind BEFORE they go out and select an underlying to trade. However, at SJ Options we’re all about studying and knowing just a FEW underlying to truly understand how it behaves under various market conditions.

At that point, we effectively flip the script and can choose a strategy based on the underlying’s behavior we studied so meticulously.

There are only two main items to evaluate before you choose the type of options strategy you want to implement in your portfolio – and that is 1) the projected direction of the underlying and 2) the velocity at which that underlying will move.

Direction of the Underlying
The underlying can move in three directions: 1) up, 2) down, or 3) sideways (stagnant).
Velocity of the Underlying
The velocity of the underlying is how fast the underlying will move in any direction. It can move quickly or slowly to its destination.

In essence, it’s really that simple. Let’s break it down even further.
Step 1: Determine the Direction of the Underlying
Many of us use technical analysis while others use a fundamental analysis approach to evaluate an underlying. The best way is to use a combination of both.

We recommend using technical analysis first. Chart the underlying and visually make out the direction of where it is going. Once you establish a direction, confirm it with fundamental analysis.

For example:

Let’s say you invested in RUT aka the “Russell 2000” index. Through technical analysis, you establish that the underlying is rising in value. Now it’s time to confirm that direction with fundamental analysis.

That’s when you look into economic and market indicators such as: employment, inflation, consumer activity, GDP, and investor activity.

You’re looking for trends that support your conclusion. If you find substantial information that supports your technical analysis, then you have confirmed the direction of the underlying.
Step 2: Determine the Velocity of the Potential Underlying Move
Understanding the velocity is combination of two things: 1) implied volatility and 2) market events.

Implied volatility is the up-and-down movement of the market. It’s measured by the standard deviation from the expectation. Historically, volatility is around 20% a year or 5.8% a month. Generally, volatility is created due to uncertainty from real market events.

Market events come in many forms. They could be scheduled economic reports to irregular significant events to unexpected disasters (natural or man-made).
Here are a few examples of market events.

Economic Reports: Inflation, Jobs Data, GDP Growth, Consumer Confidence, etc
Irregular Significant Events: Presidential Election, Government Official Change, Expiring or Creation of New Laws, etc.
Unexpected Disasters: 9/11, Hurricane Katrina, Japan Tsunami, etc

By breaking down the components in these two ways, we can better manage the approach to choosing the right options strategy. It really is that simple.

The problem that most people encounter is analysis paralysis. This paralyzing effect occurs when investors or traders over-analyze the situation by introducing various technical indicators or tools that supposedly provide another layer of information in order to reach that elusive “perfect” option trade.

Luckily for you, in our options course we teach you the best possible way to eliminate the excessive information that leads to this paralysis.

Let’s build wealth together. Happy trading!