Trading Long Options Without Short-Changing Yourself

It’s not unusual for option traders to begin their journey by buying calls and puts. Armed with a fearless attitude, they often don’t put much thought into their actions and end up with losses in their trading account after a few trades—not exactly a success story.

Many experienced traders use a clearly defined set of rules and money management principles. They enter trades for a valid reason, try to put the probabilities on their side, and apply smart money management principles before, during, and after a trade. And they do this over and over again.

If you’re thinking of buying options—puts or calls—keep in mind that trade decisions are often deeply rooted in understanding volatility, time, and price. Success in options trading isn’t always about gut feel. It’s about careful analysis, structuring your trades, and managing risk.

How can you strive to get consistent results from a simple options-buying strategy? Consider these five elements to help get you started on a smarter path.

1. Pick and Choose: Selecting Options

Too many choices can be overwhelming and challenging. But you can probably strike many off your list due to lack of volume, low open interest, and wide bid-ask spreads.

Some options have a large pool of buyers and sellers, whereas others sit idle with little or no activity. The lack of liquidity could end up being costly and even potentially turn a winning trade into a losing one. That’s because of the potential for price slippage, or the difference between the price at which you expect to get filled and the actual executed price of an entry or exit order. So, how can you size up options liquidity? Two important indicators can help—volume and open interest. Taken together, they can give a sense of whether an options contract is very liquid, sort of liquid, or gathering dust.

More liquid options contracts tend to have more strikes and expirations to choose from. They also typically have narrower bid/ask spreads. Liquidity is important for active traders in fast markets and/or near expiration dates—that’s when opening or closing a position might be a more pressing issue (see the sidebar: “Taking Stock of Liquidity”).

2. Analyze Momentum and Trend

Once you’ve selected an underlying instrument based on liquidity thresholds, your next step is to consider assessing momentum and trend. When you’re buying an option, you want it to move fast in your desired direction. Options are decaying assets that are headed toward expiration. With each passing day, the option will lose a little bit of value based on time decay, or theta. A stock could be moving in the right direction, yet if it doesn’t move fast or far enough, it could become a losing position.

So, how can you attempt to put the probabilities in your favor around momentum and trend? Looking at a price chart could help. There are many ways to analyze a price chart, but let’s start with identifying a possible trend. A stock can do one of three things at a time—trend up, consolidate sideways, or trend down.

From the Charts tab on thinkorswim, bring up a price chart and determine if the stock is in a clear uptrend (see figure 1).

But direction isn’t enough. The trend has to have momentum. A slow grind can make you right directionally, but theta could drag you down. So, consider adding volume and some momentum indicators such as the Relative Strength Index (RSI) and stochastic oscillators into the mix. If the trend is up and the additional indicators suggest strong momentum, there’s a chance the stock has the strength it needs for the trend to continue.

As a long option trader, you could consider buying calls in a dip in the longer-term upward trend. Puts work similarly but in reverse. You want to look for short-term strength in a longer-term downtrend.

3. Assess Implied Volatility

As long option traders, you want to be on the right side of implied volatility (IV). If IV is too high, options are considered expensive. That’s because of the extra premium built into the option to mitigate the risk of the market maker who’s selling it to you. For example, IV will often rise before an earnings report because traders anticipate a possible big move based on the event. After the event, IV could drop. As a result, a call option could potentially decline in value even if the underlying goes up.

How can you tell if IV is expensive or cheap? Look at its current value in relation to how it’s moved over the previous 52 weeks. You can do this using the Current IV Percentile in the Today’s Options Statistics section of the thinkorswim platform.

The IV percentile over the last 52 weeks oscillates between 1% and 100%. As an option buyer, you may want to see this reading as low as possible in relation to where it’s been over the previous 52 weeks.

4. Select Strike and Expiration Dates

One of the biggest enemies of long options is time. So, you want to consider an expiration that gives you enough time for your forecasted price move to work. The intention usually isn’t to hold the position for that long. Instead, you want to try to minimize the negative effects of theta while you’re in the trade. Theta tends to be smaller in the early days.

You also want to factor in any anticipated major news announcements or earnings reports that might come up while you’re holding the position.

The strike you select can have a lot to do with how much you pay for the option. In-the-money (ITM) strikes tend to be more expensive than out-of-the-money (OTM) strikes. How do you pick a strike? This is where delta comes in. Delta rises in a “convex” (accelerated) manner until it gets just past the at-the-money (ATM) point, and then it begins to slow down. It’s like a gas pedal in a car. You increase the pressure on the pedal until you reach a certain speed, then gradually reduce pressure on the pedal. You’re still going but at a reduced rate of speed.

Each trade is different, but generally delta acceleration kicks in at the 30–40 range. And if the underlying goes in your direction, you could get the most delta benefit. Because these options are slightly OTM, they will likely be a little cheaper but also carry a little more risk because they don’t have any intrinsic value and therefore have a higher probability of expiring worthless versus ITM options. And if the trade goes against you, that delta convexity could also slow down.

5. Position Sizing: Not Too Small, Not Too Big

Position sizes play a big role when buying options. Trade too big and you can wipe out your account. Trade too small and you may not be using your capital efficiently.

How much should you risk? This is where trader discretion kicks in. You may not want to risk more than an actual dollar amount or percentage of your account value on a single trade. That may help keep your “risk of ruin” at bay if you’re following a disciplined, rules-based system.

Consider two risks when figuring out position size:

• Portfolio risk. How much of your total portfolio are you going to risk on one trade?
• Trade risk. The risk of an options contract is the entire premium you pay. That premium will be your trade risk and could determine how many contracts to buy.

Let’s look at an example:

• Account size = $50,000
• Risk per trade at 1% = $500 (portfolio risk)
• Premium on ATM call option = $2.50
• Total premium per contract ($2.50 x 100) = $250 (trade risk)
• Number of contracts to buy = portfolio risk ($500) divided by trade risk ($250)
• $500 / $250 = two contracts

Your intention may not be to risk the entire premium, but it makes sense to use the entire premium when calculating your risk.

Just because the calculation shows you can trade two contracts doesn’t mean you can “set it and forget it.” Once your trade is executed and you have the position in your account, there are at least three ways to help manage risk:

1. Maximum premium loss. Set a dollar amount of premium lost as your trigger to exit the trade. For example, this could be $250—and because you’re trading two con­­­tracts, it would be $125 per contract.
2. Technical stop loss. If you have a long call position and the uptrend of the underlying reverses and takes out the most recent low, it could be your trigger to manage risk and recognize something has changed.
3. Time. As time passes, theta increases. If the trade isn’t doing what it’s supposed to be doing, you might want to exit the trade after a certain number of days.

Once you’ve bought an option (or two, or three), watch and manage your position. There are no guarantees, regardless of how well you follow a plan. Win or lose, you should consider exiting at a predetermined price. Hopefully you’ll win more than you lose, and then start the process over again—rinse and repeat.