When I surveyed participants about putting together a short to medium term option trading strategy, the number one question I received was which options to preselect: out-of-the-money (OTM), in-the-money (ITM), or at-the-money (ATM).
I usually have to backtrack a little bit and review the highlights of short to medium term strategies.
These are much different strategies than most traders and investors use. Typically investors and traders are thinking along the lines of being in a position for at least six months and maybe a few years or longer. They are in it for “the long haul.”
There’s nothing wrong with these long term strategies. In fact, I think they’re quite good for certain types of traders and investors. But, I have found, it simply doesn’t fit my trading style. I would rather see consistent high-percentage gains on low-risk, short-term trades.
Here are the highlights of short to medium term option trading strategies, including my thoughts on pre-selecting options. There are five steps in all.
1. Create a Pick List
Unlike many traders, we don’t want to scan hundreds of tickers a day. We don’t have to. That’s because we can use filters that automatically pull up the best candidates that might be ripe for an option trade.
Our filter chooses option candidates based on both fundamental and technical factors. And frankly, the fundamentals don’t play much of a role in my trades. That’s because fundamentals rarely impact a stock’s price in the short term.
Many brokerage systems now allow you to program in at least parts of technical and fundamental filtering criteria. As part of our Trading Trainer member site, we’ve made custom filtering algorithms that specifically filter those tickers worth focusing on. This saves our members time from having to try to fiddle with their brokerage systems. Con-figuring some brokerage system may be an overwhelming task and worse, some may not be flexible enough, to provide the intended results.
When all is said and done, there may be a dozen or so stocks on this pick list at any given time. This makes it possible to find great option trades in less than 30 minutes a day.
2. Create a Hot List.
After we’ve got our pick list, we invest some time doing in-depth analysis. Based on our criteria, we might pull out two or three or four stocks onto what I call our “hot list.” These are the stocks we actively watch and are ready to take money out of our account and invest in.
When — and only when — we have an underlying stock graduate to our hot list do we then preselect the associated option.
3. Preselect an Option.
Three of the most common option trading acronyms are OTM, ATM, and ITM.
OTM – Out of the Money
When an option is “out of the money,” it has not yet reached the strike price. The option has no intrinsic value, only potential value based on time remaining before expiration, expectations of underlying stock price movement, etc.
ATM – At the Money
An option that is “at the money” has reached the strike price. An option that has reached its strike price can now be exercised.
ITM – In the Money
When an option is “in the money,” that means it has gone beyond the strike price. Now the option has intrinsic value not based on speculation.
It is helpful to know shorthand abbreviations like these because they are used so frequently. So if you weren’t familiar with these, now you are!
So which one do we choose?
It’s important to know which option variable(s) you’re trying to profit from. There’s time decay, there’s volatility movement, and there is the directional movement of the underlying stock.
The effects of time decay and volatility actually add two dimensions to how an option price moves. What I mean by this is that you can have an underlying stock price moving one direction in its price while the option moves the opposite simply because the effects of time decay and volatility are working opposite the directional movement of the underlying stock.
This is a difficult subject, so let me try to simplify it… there are two components of an option premium. There’s the intrinsic value and the time value.
The intrinsic value has a one-to-one relationship with the underlying stock price. A call option with a $50 strike price has $1 dollar of intrinsic value when the underlying stock price is at $51, $2 when the underlying stock price is at $52, $3 when the underlying stock price is at $53, and so on. Very predictable.
The time value depends not only on the underlying stock price, but also on time decay and volatility. The time value looks like a bell curve when plotted versus the underlying stock price with the highest point being when the underlying stock price and the option strike price are equal.
How high the bell curve gets depends, again, on time decay and volatility. Time decay causes the bell curve to drop at an exponentially increasing rate as you approach expiration. Volatility is probably the hardest variable to predict. An increase in volatility causes the bell curve to rise while a decrease in volatility causes it to fall. Understanding how volatility changes and by what degree it can affect the time value of an option premium are complex subject and outside the scope of this blog post.
Generally, the options we preselect are for strategies where we are either trying to profit from an option’s time decay or from a directional move of the underlying stock or both.
In general, if you are trying to profit off time decay, we incorporate a strategy where we sell a near-term option that is deep enough in-the-money that the underlying stock price won’t move and the option will expire worthless. Some strategies like this include covered call writing and using vertical spreads.
When profiting from a directional move, we buy far out-in-time options so the decay of time is minimal. We then trade options that are somewhere from at-the-money to in-the-money. If volatility change is probable, it’s always smart to error by going deeper in-the-money.
Of course if you are trying to profit from time decay and a directional move, a near-term at-the-money or in-the-money strategy that incorporates selling an option may be in order, but realize you are trying to manage two variables which actually creates four possible outcomes to think about.
Okay, with options preselected and while we’re monitoring our hot list, we look for a set-up — like a breakout — that correlates to some kind of entry point.
4. Watch for an Entry Signal.
Entry signals we look for may include a gap down or a gap up on higher-than-average volume; an established trend with a small swing away from the trend followed by a big swing back into the trend; a “Short-Term Trend-Following” setup; or a variety of other signals.
Of course, we always look for follow-through to confirm the signal we’re going to enter a trade on. If there is no follow-through (and the price moves opposite of what we expect), we abandon the trade.
5. Watch for an exit signal.
Assuming we’ve been given a valid entry signal with follow-through, we enter the trade and then plan our exit. And, in fact, my exit strategy is always in place before I ever enter a trade.
Here’s my general rule for our technical exit: “Always exit a trade on the same signal that caused us to enter the trade.”
So whatever signal produced the entry should also be the exit. Said another way, I leave through the same door I came in through. This keeps it simple.
Of these five steps I’ve shared with you, I believe Step 5 may be the most important of them all. How we exit a trade (and the discipline we use to make our exits) could make the difference between small gains and large gains, small losses and big losses.
Based on my experience, I believe it is absolutely worth spending time to master your exit strategy whether your preselected option(s) are ITM, OTM or ATM.