The 10 Keys To Successful Stock Options Trading Key #3

This is key #3 in a 10 article series. This time we will discuss how to choose the underlying stock and how to choose the best options to trade on that particular stock.

(1) The company financials, especially the P/E ratio. The P/E or Price to Earnings ratio is the stock price divided by the earnings per share and is a good indication of the strength of the company. The average P/E over the S&P 500 is about 15 but it varies from industry to industry so check the average for the industry the stock is in. Generally a high P/E indicates a company with strong earnings and growth potential.

(2) The amount of cash the company has on hand, the amount of debt they have and the gross profit margin (defined as the gross profit divided by total revenue). These indicate the company's stability and profitability. Ideally a strong company will have a lot of cash, low debt and a high gross profit margin.

News from any number of online web sites, check my last article for a good list. Look in particular for any earnings or split announcements, any economic data being announced or any other company specific news that may affect the stock price.
Check the industry the stock is in and how it is performing. Once you have picked a stock that you think will move either up or down then you need to look at the options chain to see what options are available on that stock.

The options chain displays the expiration date, the strike (or exercise) price, the bid and ask price, the daily volume traded and open interest (the number of options contracts that exist). Let's look at each component in turn.

When deciding on the best option to trade look at the amount of time until expiration. You never want to hold onto an option that has less than 30 days until expiration because options get cheaper as time goes on and during the last 30 days time decay (as it is called) speeds up. Therefore buy an option with at least 60 to 90 days until expiration.

Consider also how much intrinsic value the option has (defined as the difference between the strike price of the option and the underlying stock price). You should ideally buy an option that has a similar strike price and underlying stock price or one that has a slightly positive intrinsic value.

The difference between the bid and ask price is called the spread. If you place a market order you will pay the ask price if buying or you will receive the bid price if selling. If you don't want to pay the market price you can place a limit order somewhere between the bid and the ask price but be aware that if the price of the option moves away from your limit, your order will not get filled.

Daily volume traded is not a major factor in deciding which option to pick but open interest is. There should be at least 100 contracts open so there will be enough buyers when you want to sell your option.

One last consideration when deciding what option to buy is the delta of the option. The Delta is one of five so called "Greeks" which refer to the components of how an option is priced. The Delta is the most relevant of the Greeks and indicates how much the option price will change for every $1 movement in the underlying stock price. For instance if you buy a call option in XYZ Company that has a Delta of 0.65 then each time the share price of XYZ moves up a dollar your option will increase $0.65 in value. Obviously the higher the Delta the better it is for you but options with a higher Delta tend to cost more to purchase.

Stay tuned for Key #4 when we will look at how to decide when to place your trade and how to identify a good entry point.

US Government required disclaimer: Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of the Characteristics and Risks of Standardized Options. Copies of this document may be obtained from your broker, from any exchange on which options are traded or by contacting The Options Clearing Corporation, One North Wacker Dr., Suite 500 Chicago, IL 60606 (1-800-678-4667).