When you’re shopping for spaghetti sauce, having several choices is great. Of course, options trading involves unique risks and is not appropriate for everyone. But, if you’re an options trader, it’s kind of the same thing with options strategies. But with all those various strategies, strikes, and expiration dates, how do you choose?
When you’re starting with, say, 60 options strategies, you need a process to get that number down to a manageable level. Start with three basic questions:
- Are you bullish, bearish, or neutral? This answer can narrow a list fast—by half or more. If you’re looking for a market advance, you’re likely not shopping in the long put verticals aisle.
- Is it a buyer’s or seller’s market for options? In other words, where’s volatility being priced in the short term and longer term, and how does that rank against historical levels? This narrows a list even further.
- Are you looking for a strategy with a high probability for success or high potential reward? Trading would be a lot easier if you could have both, but that’s not the way it works. It can feel like the ultimate trade-off. When you swing for the fences, it’s great when you connect, but you often skulk back to the bench after striking out. Or you can grind it out with base hits—unglamorous and labor-intensive, but it gets the odds working for you.
An SPX Example
Suppose you expect the S&P 500 Index (SPX) to trend higher in the weeks to come. Now look at the Cboe Volatility Index (VIX). Let’s say it’s in the upper 20s. You check the chart and see that’s the high end of where it’s been in recent days. (Note: You can also get a volatility [vol] snapshot by looking at the implied volatility and historical volatility percentiles for any stock, index, or exchange-traded fund on the thinkorswim® platform on the Trade tab > Today’s Options Statistics.) Maybe your convictions aren’t terribly high; you think this rally could be a slow burn, and you typically like to play high-probability grinder ball.
So, you’re looking to the upside. Short and neutral strategies are out. No long puts or put verticals, and no strangles or iron condors.
Vol is elevated, and your conviction isn’t super high. Rule out long calls with high vega. You might also rule out buying low delta and low vega calls because they’d be low probability. A long call butterfly spread (with the middle strike centered around your upside target) could fit the bill. But it’s not a high-percentage play.
From here, it all depends on your risk tolerance and personal preference, but the leading candidate looks to be a short put vertical with a few weeks until expiration. Next, you can look at strike selection, keeping that ever-critical trade-off between high reward and high probability in mind.
Above all, you’ve created a process by which you can narrow down the options strategy choice set. Now, about that spaghetti sauce? You’re on your own.
Doug Ashburn is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.