Selecting the Right Option

[skiehawk11]

Selecting the right option is pretty tough business. I'm going to do my best to explain how to pick the right options price based off some of my experiences and personal research. Please add to, correct and or expand what I state here.

Option premiums are determined by the underlying greeks. The five general greeks (1st order derivatives) are delta, gamma, theta, vega and rho.

FYI: All examples have made up greeks.
OTM = out of the money
ITM = in the money
ATM = at the money

In general terms, options have two types of value: intrinsic and time value.

Delta measures the price movement of an option when the underlying stock moves up or down one dollar.

Example: SPY AUG 12 CALL 130 has a delta of 50. This means that if SPY moved from 134 dollars to 135 dollars, the options price will increase by 50 cents.

Gamma measures how much the delta of the option will increase or decrease for every dollar the stock moves.

Example: SPY AUG 12 CALL 130 has a delta of 50. The gamma displayed is 1.4. This means that if the stock moves up a dollar, delta will increase from 50 to 51.4. This then translates into the options price moving up 51.4 cents for every dollar increase in the stock instead of 50 cents.

Theta tells you the rate the option will lose value per day as it approaches expiration.

Example: SPY AUG 12 CALL 130 has a theta of .03. This says that the option value (price) will lose 3 cents a day. This assumes that all other greeks are held constant. Theta increases or the rate of how much the options price loses increases as the expiration date draws closer.

Vega shows the rate the option price will change as the implied volatility of the stock changes.

Example: SPY AUG 12 CALL 130 has a vega of .01 and an implied volatility of 32.01. If implied volatility increases from 32.01 to 35.01, then the price of the option will change by (35.01 - 32.10) x .01 = .03 or 3 cents.

Rho estimates how much the option price will change if interest rates change. For this reason, rho is not as important as the other four greeks.

Example: SPY AUG 12 CALL 130 has a rho of 0.05. If the interest rates increase by 1%, the options price will increase by 5 cents.

EDIT: I'll add scenarios to this post when I get some more time.

[skiehawk11]

I generally play the riskiest and most volatile option plays out there, but the principles on how I select options can be used throughout other options trading.

Selecting an option isn't as easy at picking an OTM option and doing the simplified option leverage calculation:

[(Strike Price * delta) - premium] / premium

Generally, the OTM options will give extremely large leverage just because of the kind of math involved, but as in all things, one size doesn't really fit all.

I base how I select my option based on the price (1 to 2 dollars, I may go a littler lower to 50 cents or so) of the option, where we are in the week (extremely important) and

I also look at where in the week we are (Time premium analysis). When a new weekly option is created you pay quite a bit in time premium because there is the potential for a large stock to increase.

I also look to see where the security is trading at in terms of price action and strength of the current trend. This will help you make sound judgement calls on what option to buy.

For instance, I had 4 trades in AAPL this week.

My first trade I opened up the Friday before for the week 4 options. I usually target calls 10 - 20 strikes OTM. I do this since they tend to trade cheaper (falls into my range).

Last weeks close was pretty strong, but we were trading above the resistance 3 line. However, I was up for the week and decided that risking 250 dollars for a couple 100% return was worth it. As it turned out, I got "lucky". Monday was a smashing success.

Tuesday, I did the same thing, buying an option that was 10 to 20 strikes out. AAPL opened higher and I was actually up about 30 to 40 percent, but then AAPL tumbled and so did my investment. With that extreme amount of leverage I lost 60% of my 250 dollars in a matter of a few hours. I sold and closed my position for a loss. However, I was still up by a few hundred percent because of my trade on Monday.

Wednesday, I didn't buy mainly due to work obligations the day before, but I would've played options a littler closer to ATM since expiration was nearing, and time premium was dwindling.

Wednesday before the close, I bought again near ATM calls (675). Thursday, I lost 30% before closing my position out.

Thursday, I bought at 660 (pretty much ATM) before the close. I sold today for around 500% return.

So, for 4 days of trading, I invested 250 dollars each. I lost a total of 225 dollars plus commissions (~245 dollars), but my 2 trades that won, I won over 300% for the first one and 500% for the second one. So I made a total 2,000 dollars in profit approximately. So, I still ended the week positive.

Some caveats, I wasn't able to trade 250 dollars exactly on each trade, but I get pretty close to it for the most part. You need nerves of steel and a love for risk taking. You also need patience.

I cannot teach you trading. It is a skill honed by practice and nothing but practice. Everyone has a different style of trading. My style may not be suitable for others. However, I get the math and reason behind my trading style and it works for me. It may eventually stop working, but until it goes broke, I'll keep trading.

Hopefully, this has some useful information for everyone. Those who trade options, please post on how you determine strike price and expiration of your options. I always want to learn more.