When I identify a candidate for a trade, my goal is to eliminate all reasons to “not” make a trade, whether it be directional or non-directional. Once I identify a probable direction, I look for the following:
a) What is my target stock price?
b) When will it get there?
c) Are there any known news events within my time horizon (e.g., earnings)
d) Where is my technical prognosis wrong?
It a candidate is a go, I need to select a strategy.
This post is going to address the simplest of all strategies (long calls or puts) and how I select strikes and expiries.
One of my directional systems uses a crossover of a baseline. If the baseline is below the 200 simple Moving Average and the cross is bearish, I consider a bearish trade (vice versa for bullish setups). The setup is validated if two confirming indicators are in alignment.1
A case study on CRWD
CRWD corresponded to my criteria on April 21st, 2022.
The simplest bearish option strategy is long puts. Puts give the right, but not the obligation, of their owner to “sell” a stock at a given strike price on or before their expiration. Puts will increase in value primarily (but not exclusively) based on the stock declining in price.
In this example on CRWD, I needed to choose the best strike and expiry that would allow me to reach my minimum trading goal – to make two times my risk. If I am willing to risk 2% of my account, I want to try to make 4%.
Step 1: Choose expiry.
For this case study, my prognosis was that CRWD will move down to my target over the following two weeks. Options are depreciating assets, so I wanted to give the stock ample time to reach my target so that their option value would not bevdegraded significantly over my planned holding period.
I generally choose expiries that are a minimum of 45 days to expiry as “theta decay” of the value of options accelerates faster starting at 30 days to expiry.
Note that CRWD earnings were slated for June 2nd (42 days from April 21st). It is preferable to choose expiries after earnings so that any increase in increase in premium due to implied volatility can be captured. In this case, my ideal expiry would be June 3rd. However, volume was poor so the June 17th expiry was the best (57 days to expiry). This gave enough time for CRWD to make its expected move; its put options would not significantly decline in value due to theta if it took a few weeks to meet my target.
Step 2: Choose strike price
The primary mechanism for option increase and decrease in value is “delta.” Delta is a positive measure for calls and a negative measure for puts. If the delta value of a put option is -0.65, this means that for every $1.00 decrease in price of the underlying stock, the value of the option will increase by $0.65. If a call option has a +0.30 delta, its value will increase $0.30 for every $1.00 increase in the underlying stock’s price.
I am going to add one additional layer to delta. Its value is not constant. As the price of the underlying stock changes, in the case of CRWD, the delta of $195 strike puts for example, will increase as the stock moves down. I am describing “gamma” here, which is essentially the rate of change/momentum of the delta of options. Herein is where many novice and detail oriented experienced traders get too involved with the “Greeks”.
I am going to simplify this into something actionable (my rule of thumb) - I want to choose the strike that has the highest rate of change of value increase if the underlying goes my direction. This happens when the initial delta of the chosen option is between 25 and 35.
For an interesting and more in-depth description of the relationship between delta and gamma, check out https://www.optiontradingtips.com/greeks/gamma.html.
Step 3
Write a trade plan that clearly identifies the why & where as well as the when to take a profit or loss.
If readers are interested in finding out what happened in the CRWD case study, do a back-test (it was successful by the way). It is by far the most useful exercise you can do to “practice” trading. My videos posted last week in Practice Makes Perfect should be able to guide you. The purpose of this post was to provide readers a method for choosing options. Management and adjustment of trades will be addressed in a future post.
Actionable Trade Candidates for Week of June 13th…
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