Okay, at this point, through the use of fundamentals, we have filtered to the top the best of the best stocks to watch — the ones that will give us the best returns when we trade their options. Then, using technical analysis, we have found a stock or two on our watch list that we are ready to open a trade on. Now, it’s time to pick which options we should trade. Let’s step back one second and refresh ourselves with the material from Strategy One in order to remember why we trade options. Options allow us to control a stock for a fraction of the price of actually owning it. Trading options is like supercharging your returns from the typical 10-20% you’d expect from an average stock every year, to 100-200% that you’d expect from an average option every two months. We can take advantage of the same dollar-for-dollar price movements that the underlying stock benefits from while at the same time paying typically less than 10% the cost of the stock to control it. It’s taking advantage of the gains, if you will. Now, let’s get back to the subject matter at hand. There are so many options to choose from. First, we need to know whether we are interested in call or put. Then, we have to know what strike price we are interested it. Options strike prices run the gamut from “out of the money” to “at the money” to “in the money.” Then, we have expiration dates. Options always expire on the third Friday of the month. Selecting the right options is one of those subjects that can be as complicated or as simple as you want to make it. Beware of options traders that start talking to you about an analysis technique utilizing Greek letters, otherwise known as “the Greeks,” and other more complicated techniques to analyze options. Options allow us to control a stock for a fraction of the price of actually owning it These advanced topics, in our way of trading, only complicate the subject. When in doubt, simplify. For the record, it is often that options traders who talk about the Greeks don’t actually know what they are talking about. So, we’ll go back to taking the simple approach in selecting the right options. Okay, before we begin, here are two concepts we need to solidify in our minds. The first concept is that options prices will move just about dollar for dollar with the underlying stock’s price when it is “in the money.” Second, options prices become very volatile during the last month before it expires. See graphs on the following page. With those two simple concepts, we derive the following two rules. Rule number one — we always try to buy “at” or slightly “in the money” options to take advantage of the dollar for dollar price movement. Rule number two — we automatically sell any options that are equal to or less than a month from expiration. Okay, let’s set up an example scenario and work through how to pick winning options. An example stock could be IBM. Let’s say IBM is currently trading at exactly $100 per share in May. The first thing we are going to do is setup a “comparison” matrix. We’re going to grab a pencil and scrap paper and draw a two by two matrix. Ultimately, we’re going to systematically fill in the price of four different options into the four different boxes so we can quickly compare and select the best options. With our empty matrix handy, we are going to visit the Chicago Board of Options Exchange website. The website address is CBOE.com. There is an area of that website that will allow us to enter in a stock ticker. It will list out all the calls and puts that are currently active. So, while visiting CBOE.com, we’ll type in IBM. A two-column page will appear. The left column will show all the call-options categories, and the right column will show all the put-options categories. When in doubt, simplify And, remember, we always need to buy our options one month out. Our rule says that we will sell any options that becomes equal to or less than a month from expiration. With those guiding bits, we will want to give our stocks anywhere from two months to five months to appreciate. Now, there is flexibility in that. On an aggressively trending stock, we may cut that shorter. On a stock with just a slight trend, we may want to extend the time. In general, two to five months is appropriate. And, we want to add a month so we don’t get caught in the last month before the options expire. So, when all is said and down, we are looking at options that are three to six months out. Coming back to our example, let’s say that IBM has had five dollars of upward price movement in the last three months. To make the type of returns we expect, we would probably need at least two months of appreciation and an extra month so we have time before the options expire. Okay, so it is May. We want to look down the list of calls and find the series of August Calls, which is three months out from the current date. On our matrix, as a label to the left of the first row, we want to write down “August.” Now, once we find the August series of calls, we want to find the options that are “at” or slightly “in the money.” In this case, it would be the August 100 Calls. On our matrix, as a label to the top of the first column, we want to write down 100. In the first cell corresponding to August for the row and 100 for the column, we want to enter in the current ask price for the options. For our example, the IBM August 100 Calls are $10. Now, we want to find the next August options that are farther in the money. Usually, for underlying stocks that are trading at over $50, those options strike prices will be in five dollar increments. So, for our example, we want to find the IBM August 95 Calls. On our matrix, as a label to the top of the second column, we want to write down 95. In the next cell over, corresponding to August for the row and 95 for the column, we want to enter in the current ask price for the options. For our example, let’s say the IBM August 95 Calls are $16. Use a sixmonth chart to do your technical analysis For the next row, we go to the next month series of options, which, in our example, are October options. On our matrix, as a label to the left of the second row, we want to write down “October.” Now, we look up the IBM October 100 Calls and the IBM October 95 Calls prices and fill in the second row’s cells.We’ll say those values are $14 and $20 respectively. See the following table. So, first we’ll eyeball those values, and we’ll draw some conclusions. First, as the strike price increases, we see we’ll pay a higher premium for going further “in the money.” In fact, the farther we are “in the money,” the closer the price movement is to dollar for dollar with the underlying stock. The other conclusion we can come to is that the further out in time we buy our options, again, the price goes up — therefore, we’ll pay a premium. In other words, if we need more time for our stock to move, we’re going to pay for it. So, how do we pick the best one? With the four prices organized in this way, you can quickly see the whole picture. Now, we want to take into consideration the following questions. How much money do we have to invest today? How much volatility does the underlying stock have? How well is the underlying stock appreciating? Recall that when we buy “at the money” or “in the money,” options we’ll get close to dollar-for-dollar price movement with the underlying stock. The further “in the money” we buy, the closer we will get to dollar-for-dollar price movement. For our example, if the underlying stock, IBM, moves $10, then the If we need more time for our stock to move, we’re going to pay for it IBM August 100 Calls will move to $20, the IBM August 95 Calls will move to $26, the IBM October 100 Calls will move to $24 and the IBM October 95 Calls will move to $30. The return’s on-investment for those four scenarios are 100%, 63%, 71% and 50% — respectively. As a rule, we like to buy the cheapest options. However, if the stock is slowly but surely appreciating, we may want to buy the longer out options. If the stock is all over the place, we may want to pad our savings by buying options that are farther “in the money.” Our final test is to look at the amount of open interest. That is the amount of options in circulation at any one time. So, if we are options traders and we want to buy and sell options, we need to have a lot of open interest. If we own a contract of IBM August 100 Call options and the open interest on those options is one contract, then we will have a problem when we want to sell those options. There may be nobody around to buy them. As a general rule, we will not buy any options if the open interest in less than 100 contracts. As part of the TradingTrainer.com community, we are constantly sharing realworld examples of how an options price movement moves with that of their underlying stock and the thought process behind how we picked a particular option in a particular situation. Again, we try to keep the process simple, and we rely on repetition to get good at the skill.