by: Billy Williams
To maximize profits from option spread trading, analytical tools can help to identify the best security to use and the best timing to execute the trade.
Learning to use these tools will help us maximize our profit and minimize our risk. Today’s traders have almost too many tools at their disposal and they include some which are widely available, free of charge and relatively simple to use.
Other tools are expensive. They include proprietary software solutions that are designed to provide complex market evaluations in real time.
I use Yahoo! Finance charts, which can be viewed from the screen-capture images in my previous articles. Yahoo! Finance charts are simple to set up, have reasonable market delays and show key technical indicators. My options trading brokerage, OptionsXpress, offers technical tools similar to the tools provided by other brokerage houses. The tools offered by your brokerage will have more features and you should use them to your advantage. These tools allow you to set limits on charts for warnings, entry and exit points, watch alerts for when options enter the zones you may set up and other useful tools.
The main resources an options trader needs are:
- Options pricing calculator. This helps for planning trades, determining intrinsic value, premiums, time decay, etc.
- Trend lines for 20-day and 200-day moving averages (DMA), volume, Bollinger bands, RSI, and any other indicators you might need. More indicators do not necessarily make for better performance. The key is matching the indicators to the type of trading you are doing. All that is needed for successful spread trading is to determine the major trend, or lack of it, plus potential tops and bottoms for counter-trend moves, if desired.
- Options monitoring up-to-date pricing, order fills and status.
- An options analysis package such as OptionsVue or Options Smart are discretionary. Though these tools can be useful, the best way to start option spread trading is to stick with the basics. In attempting to create the perfect system, many traders tend to include in their system every tool available. While many have claimed to have the perfect system, most of the top traders use simple tools like those explained here.
With these basic and useful technical analysis tools, you are ready to enter the realm of options spread trading. In the rest of this article and several upcoming articles, I will explain how to choose the sector, security, time, price points and the type of options spread strategy to use.
Choosing Your Option Spread Trading Strategy
At first, some of these choices might seem foreign and different option trading strategies might look alike. However, you quickly will start to see the patterns emerge. You will understand how one decision follows naturally from the technical analysis foundation and how easy it is to choose an option spread strategy based on risk tolerance and market perspective.
Before long, you will have a few favorite options spread strategies that you prefer for each type of market. This is when the fun begins and the profit starts rolling in. When you arrive at the point where you easily can assess the type of option for the market conditions, you will be well on your way to having a high probability of making profitable trades.
When I first started trading options in college, I only knew how to go long or go short. I would buy call options for stock that I thought might rise and would buy put options for stocks that I thought might fall. Initially, I had some hits and a lot of misses.
I read books about the Black-Scholes pricing model. However, despite having a good math background from engineering, I did not see the relationship with my experience in the market. While Black and Scholes created the options pricing model, people like Trader Vic became rich from trading options. The main lesson was to learn about the variety of tactics for all types of markets and to keep my trading simple. The goal of this series of articles is to explain simple techniques to begin options spread trading with a much higher level of success than trading the basic long or short side of any market.
The first step to entering the options marketplace is having some technical tools to use. One of the main problems for all traders is how to choose the market where to trade. The options trading market is somewhat easier to navigate than the general investing market because options are more restricted then stocks, commodities, mutual funds and ETFs (exchange-traded funds).
Options markets are restricted more than other types of investment markets and only some investments allow options. Many stocks and funds, as well as commodities, have limited options or no options at all.
In a previous article, I gave an example of when I was trading copper. I wanted to find options on copper futures but there were none trading within the range I needed. Options that were trading in my range did not have sufficient volume for me to enter and exit the trade easily. This is common in a lot of commodity markets and with low volume stocks or ETFs. Therefore, before you enter a certain sector, make sure that there is enough trading volume and interest. Otherwise, you might not be able to find options that meet your trade criteria and the probability of a profitable trade will plummet.
Some of the best areas for stock options include index options, leading NASDAQ components, large stock options such as Alphabet, Inc., Amazon, all the other Dow components, etc. Commodities markets are more difficult for options trading because volumes in those markets are low and only few options are available for the large number of futures trading in the commodity sector.
Best Sectors for New Option Traders
Beginner option traders and those new to trading spreads should start by trading either index options or large capitalization stock options. You should stay away from the commodities market through your initial learning period.
Finding the right options to trade at the right time and at the right strike price in the commodities futures market will be difficult and it will require a lot of your time. The exceptions to this rule are gold and silver markets, as these markets have enough volume to properly analyze with our basic tools and plenty of strike price choices.
Since most option traders are engaged in the stock market, I will focus most of my examples in upcoming articles on the stock market and include examples from the commodities market only occasionally. I will discuss in future articles the best way to select a market sector for trading and identify market trend direction.
Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.