Making Good Decisions Before Trading Options
Pulling the trigger on an options trade is the final step in a deliberate process of analysis that starts with looking at the overall trend of the market and ends with sector and individual stock analysis. You wouldn’t go out and buy a car without doing your research and comparing prices, so why should you take the risk of putting your money into the dog-eat-dog world of the stock market without giving yourself the best chance of achieving success?
A good method of giving yourself the best odds is the traditional top-down analysis approach, which includes deciding on your time frame, analyzing the market’s trend, and then picking your trading vehicle.
Before making any trading decisions, you should know your personal risk profile and the potential for losses with any trade.
Deciding on your time frame
Before making any trade, you should decide whether you are interested in a short-term (hours to days), intermediate-term (days to weeks), or long-term (months or years) trade. There are ways to trade options for all time frames, but optimizing your exposure is a key component of successful trading. If you are short-term-oriented, consider gearing your analysis toward events such as earnings reports or economic reports. In these cases, consider the following:
Past performance of the market in response to similar circumstances in the past
Past performance of market sectors and individual companies to similar circumstances
What may go against your trading plan
Markets can respond differently each time, regardless of similarities of circumstances.
If you’re interested in the intermediate or longer term, your analysis should be more oriented toward market analysis. In this case, consider the use of technical analysis indicators:
Moving averages: Choose between simple moving averages (SMA) or exponential (EMA).
Oscillators: Consider using on balance volume (OBV) and rate of change (ROC).
Trend lines: Trend lines are constructed by connecting three inflection points. They can give you an excellent idea of the market’s dominant trend.
Deciphering the dominant trend
As simple as it sounds, it makes sense to figure out whether the market is rising or falling. Important questions to ask include these:
How long has the current trend been in place? As a general rule, the longer a trend has been in place, the more likely the chance of a reversal.
What are the important support and resistance levels? Support levels are points on price charts where the markets tend to consolidate after they’ve taken a fall. Resistance levels are chart points where prices tend to top out and often reverse course after an advance.
By figuring out the dominant trend and asking important questions, you start to formulate what kind of trade makes most sense. General principles of trend trading include the following:
Trade with the dominant trend: If the market is generally trending higher, consider going long (buying). In a downward-trending market, consider going short (making a bet that the market is going lower).
Be prepared for trend reversals: Even the best-laid trading plans can be wrong. Never think that your analysis and trade execution is flawless.
The longer a trend remains in place, the more likely it will reverse.
Picking a trading vehicle
Deciding on a trading vehicle depends on what your trend analysis has defined as the major trend. Options are available for individual stocks as well as for exchange traded funds (ETFs). Some periods of time are better suited for one over the other type of vehicle.
Generally speaking, ETFs are more suitable for trading the market or specific sectors. If you choose to trade the market, consider using the S&P 500 SPDR ETF (SPY). There are literally tens of sector-specific ETFs to choose from. A good place to start your analysis of sector ETFs is with the S&P 500 SPDR series of ETFs.
Individual stocks are generally best when you are familiar with the fundamentals of a specific company, especially during earnings season and other specific events.
Be aware that some sector-specific as well as broader market ETFs are designed to use leverage. Read the prospectus carefully before trading.