A big key to an options trader's success is the ability to select the correct underlying stock. To do that, the trader needs to identify the long-term direction of the stockâwhether it is trending or in a trading range. In addition to getting familiar with how a particular underlying stock behaves, it is also important to select the appropriate option strategy for the opportunity forecasted.
When approaching a stock with a directional objective it is essential to put together an option strategy that takes into account the underlying equity's expected value at a certain time in the future. This can be tricky at times but with the help of powerful technical tools like Elliott Wave and others it can be done accurately more often than not. The rewards in the options market for the successful directional trader are well worth the effort.
Keep in mind that profits can be generated by the options trader in both trending and trading range markets. Trending markets however do have a greater profit potential for the options strategist. In a trading range, a stock will typically trade up to a previous high or down to a previous low, but will not move outside of this range. Trending markets on the other hand are limited by previous highs or lows. Uptrends are defined by a series of higher highs and downtrends are defined by a series of lower lows.
Many times when the trader is looking for a buy signal it is generated during oversold periods within a current bull market. As an options buyer the trader needs the directional trend's positive bias to overcome the time decay that continues to dissipate each passing day. Just from a practicality perspective it is wise to avoid bullishly oriented option strategies in downtrends and avoid bearishly oriented option strategies in uptrends.
It is important not to fight the trend as a directional trader especially when employing option strategies. For instance, if a stock trader goes against a prevailing uptrend by shorting the stock the stock trader can at least stay close to breakeven if the stock enters into a trading range before its next move to the upside. However, the options strategist who purchases a put option not only loses when the stock rises, but also when the underlying goes into a consolidation mode due to time decay.
One thing the options strategist needs to clearly understand is that there are some key differences when trading puts versus trading calls. For example, the call buyer can take advantage of the slower steadier trends, assuming a longer-term upward bias in the marketplace. The put buyer has the potential to accumulate profits much more quickly on panicky selling scenarios, but put traders need to be a bit more agile to exit the trade fast if the position is not working or if windfall profits occur.
Bearish positions demand a totally different approach to be consistently successful. For instance, if the trader attempts to construct the same number of bearish opportunities as bullish positions in the middle of a general market uptrend, the losses on bearish trades will counterbalance the profits on bullish trades. In a bull market, be ready for less exciting results from put positions.
The options strategist will certainly find selected bearish opportunities even in bull markets, but it is important to keep in mind that a rising market can often lift the weakest of stocks. The point is that time stops, where the trader closes out an options position in a predetermined timeframe, are even more critical on put trades. Finally, always make sure the particular options strategy matches up well with the opportunity presented. The bottom line is that the risk graph must make total sense before initiating the trade.
Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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