I tell you what – Tuesday was my best trading day of the year. No joke, nearly every one of my trades turned a profit that day.
The capstone achievement had to be Advanced Micro Devices (AMD). That one delivered a massive windfall to Weekly Money Multiplier Members.
I see a lot of new members to Weekly Money Multiplier struggle with executing options trades that last only a few days. Ironically, they do just fine with trading the stock. But profiting with options alludes them.
I struggled with this for years. It took me a lot of trial and error to boil it down to four main points: expiration selection, choosing the right strike, and understanding implied volatility.
Most option traders know about these pieces to the puzzle. But, they don’t know HOW to look at them. I want to show you how I analyze and choose the right option contract for every trade.
First, let’s start with choosing the correct expiry. When you trade options, you choose between two types of options: weekly and monthly.
Weeklies close out every Friday. You find these in highly liquid stocks like the SPY. Monthlies expire on the third Friday of every month. Every stock with weeklies has monthlies, but not all monthlies have weeklies.
For example – The SPY has weeklies and monthlies. However, a small stock like KBR only has monthly contracts.
Now, when you choose the expiration, you need to estimate when you expect the trade to finish. That means looking at what day you open the position. If you initiate the trade on Monday, and you think it will take two days to play out, then picking the Friday of that week works. However, that same idea doesn’t perform well if it’s Thursday. In that case, you want to go to the following Friday.
Pro Tip: When in doubt, go out to the following week. The last thing you want is a brilliant strategy to fail because the clock ran out.
As you get closer to expiration, the extrinsic value of the option declines at an exponential rate. For a refresher, this is what happens to the premium of an option over time.
Refresher lesson – Extrinsic value – The value of an option if it was executed right then and there less the intrinsic value. Intrinsic value is the difference between the strike price and the current stock price. If you had an option worth $2.00, a stock at $100, and a call option at $99.50, $0.50 would be intrinsic value, $1.50 would be extrinsic value. That $1.50 will go to $0 by expiration.
While picking out short-dated options pay big when you catch the timing right, they come with a lot of risks.
Your second most important choice is the strike price. A strike price at-the-money will have the highest extrinsic value possible, with no intrinsic value. As you move deeper-in-the-money, the option price goes up, but the extrinsic value declines.
I look at what’s called the ‘Delta’ of an option. This number tells you how much an option price will move for every $1 increase in the underlying.
There are a few things you need to understand about delta. First, the delta at-the-money (ATM) will be 0.50. As you go deeper in-the-money (ITM) you will approach one. At expiration, all ITM options go to 1. Also, put options have negative deltas while calls have positive deltas (because puts lose value as a stock price increases).
The way I look at it – the higher the delta, the more control you have over the stock. I like to choose deltas that are one or two strikes in-the-money (around 0.60-0.70 for calls or their negatives for puts). This reduces the amount of extrinsic value decay I experience while offering the leverage of an option.
Understand implied volatility
Implied volatility plays a crucial role in option prices. This measure tells you the market’s prediction for a percentage move in the stock based on option demand. The number you read is the volatility extrapolated to 365 days.
For example, if I read implied volatility (IV) of 25 on IBM, the options market is pricing in a 25% annualized move (even if the options expire in 30 days).
The higher the implied volatility, the more expensive an option becomes. We tend to see IV spike during selloffs and fall during uptrends.
When you play stocks with short-term expirations, generally, you needn’t worry about IV. It typically doesn’t have much of an impact.
However, earnings events are the exception. Implied volatility rises significantly into earnings and then falls immediately afterward. Traders buy options, but don’t know whether a stock will move up or down, which sends option prices soaring. When the company releases earnings, the traders know what to expect and adjust their positions accordingly.
So, when trading short-term options, always watch out for earnings events. They can inflate the price of an option, which then plummets after the announcement.
Practice with a mentor
Trading is like any other skill. The more you practice, the better you get. It’s a lot easier when you can look over a professional’s shoulder.
That’s why I give Weekly Money Multiplier my all to ensure you get your fill of education, content, and training to make you a better trader today.