How to Pick a Stock For Option Trading?

The six steps follow a logical thought process that makes it easier to pick a specific option for trading. Let's breakdown what each of these steps involves.

1. Option Objective

The starting point when making any investment is your investment objective, and options trading is no different. What objective do you want to achieve with your option trade? Is it to speculate on a bullish or bearish view of the underlying asset? Or is it to hedge potential downside risk on a stock in which you have a significant position?

Are you putting on the trade to earn income from selling option premium? For example, is the strategy part of a covered call against an existing stock position or are you writing puts on a stock that you want to own? Using options to generate income is a vastly different approach compared to buying options to speculate or to hedge.

Your first step is to formulate what the objective of the trade is, because it forms the foundation for the subsequent steps.

2. Risk/Reward

The next step is to determine your risk-reward payoff, which should be dependent on your risk tolerance or appetite for risk. If you are a conservative investor or trader, then aggressive strategies such as writing puts or buying a large amount of deep out of the money (OTM) options may not be suited to you. Every option strategy has a well-defined risk and reward profile, so make sure you understand it thoroughly.

3. Check the Volatility

Implied volatility is one of the most important determinants of an option’s price, so get a good read on the level of implied volatility for the options you are considering. Compare the level of implied volatility with the stock’s historical volatility and the level of volatility in the broad market, since this will be a key factor in identifying your option trade/strategy.

Implied volatility lets you know whether other traders are expecting the stock to move a lot or not. High implied volatility will push up premiums, making writing an option more attractive, assuming the trader thinks volatility will not keep increasing (which could increase the chance of the option being exercised). Low implied volatility means cheaper option premiums, which is good for buying options if a trader expects the underlying stock will move enough to increase the value of the options.

4. Identify Events

Events can be classified into two broad categories: market-wide and stock-specific. Market-wide events are those that impact the broad markets, such as Federal Reserve announcements and economic data releases. Stock-specific events are things like earnings reports, product launches, and spinoffs.

An event can have a significant effect on implied volatility before its actual occurrence, and the event can have a huge impact on the stock price when it does occur. So do you want to capitalize on the surge in volatility before a key event, or would you rather wait on the sidelines until things settle down?

Identifying events that may impact the underlying asset can help you decide on the appropriate time frame and expiration date for your option trade.

5. Devise a Strategy

Based on the analysis conducted in the previous steps, you now know your investment objective, desired risk-reward payoff, level of implied and historical volatility, and key events that may affect the underlying asset. Going through the four steps makes it much easier to identify a specific option strategy.

For example, let’s say you are a conservative investor with a sizable stock portfolio and want to earn premium income before companies commence reporting their quarterly earnings in a couple of months. You may, therefore, opt for a covered call writing strategy, which involves writing calls on some or all of the stocks in your portfolio.

As another example, if you are an aggressive investor who likes long shots and is convinced that the markets are headed for a big decline within six months, you may decide to buy puts on major stock indices.

6. Establish Parameters

Now that you have identified the specific option strategy you want to implement, all that remains is to establish option parameters like expiration dates, strike prices, and option deltas. For example, you may want to buy a call with the longest possible expiration but at the lowest possible cost, in which case an out-of-the-money call may be suitable. Conversely, if you desire a call with a high delta, you may prefer an in-the-money option.