Considerations before initiating an Options Trade

Analysis first begins in identifying underlying asset markets where you feel there are opportunities, particularly in that asset's options market. With these markets in mind, you are then able to obtain data on the underlying assets and corresponding options, and begin your search for profitable positions.

You must also determine the types of strategies you would like to use. Search strategy selection depends on whether you are bullish or bearish, the amount of capital you have to trade, the profit you would like to make, the risk you can afford to take, and your trading style.

There are several stages of analysis involved with trading options such as analyzing the underlying asset market, determining your market outlook, defining your risk and objectives, and choosing strategies.

Analyzing the Underlying Asset Market

Since options are derivatives and derive their value from the underlying asset, analysis normally begins in identifying the underlying asset or assets that you feel have opportunities for profitable trades. TradeStation enables you to chart price data and apply a myriad of studies that will help you find assets that fit your trading objectives. For example, you may identify an asset through analysis that has continued in a particular trending pattern with occasional pullbacks or periods of consolidation. Using additional studies, you can develop a strategy that takes advantage of buying options during the pullbacks and consolidation breakouts.

Determining Your Market Outlook

Which options search strategies you use with your trading strategy will depend on your trading capital, the amount of capital you are willing to risk on each position, the markets traded, and market outlook. Your market outlook is your assumptions for price movement, volatility, and time required for the price movement.

A simple example of selecting a search strategy based on a market outlook would be buying a call, which is a bullish strategy. Buying a call involves one leg - buying an option contract that enables you to purchase a specific number of shares of the underlying asset, at a specified price, by expiration. This is only one example of several strategies that can be used in an advancing market.

Defining Your Risk and Objectives

Along with the potential for reward, each search strategy has its accompanying risk. As mentioned earlier, before selecting the search strategy you want to use in your trade, you need to determine the amount you are willing to risk should the position become unprofitable. Some strategies offer a definable, limited risk, while others have unlimited risk.

If you are purchasing options, your only risk will be the price you paid to purchase and the commissions paid to your broker. If, however, you are selling (or writing) options, your risk is unlimited and your reward is only the premium you received when you sold the option to a buyer. This type of search strategy will also involve a margin requirement.

Your trading objectives will also play a role in what strategies you select. Are you trying to protect holdings you already have in the underlying asset? If so, there are specific strategies that can be employed to protect your holdings. If you are speculating, and have some capital to risk, then other types of strategies should be considered.

Using "what-if" analysis in OptionStation Pro Position Charts is another method of determining the risk and reward for positions under consideration and positions currently held. For additional information on using Position Analysis and Position Charting to evaluate potential profit and risk for option positions, see Identifying Profitable Option Positions, Using Position Charts to Evaluate Theoretical Profit and Loss, and Monitoring and Tracking Positions.

Choosing Strategies

Before you can begin identifying profitable positions, you will need to decide on the options strategies that you would like to use for these positions. The strategies you select will be based on several factors, including the type of market, such as trending or volatile, the amount of capital you are willing to risk as well as your assumptions for future market direction. Are you bullish or bearish? What do you think the underlying asset price will do - increase or decrease or stay the same? What is the length of time that you want to hold your position? How much capital do you have to risk? How volatile is the underlying asset?

Developing a good search strategy and knowing your risks are essential for successful trading. Employing the correct search strategy provides you with the best possible chance of winning-as well as reducing and limiting the inevitable losses. Therefore, in options trading, the better you understand the various strategies and how they are used, the better your chances of success. It is also important to keep in mind that options are multi-dimensional. Their value is determined not only by the price of the underlying asset, but also the asset's volatility, the strike price of the option, short-term interest rates, and the amount of time remaining until the option expires.

Trading options provides you with many different types of strategies. In OptionStation, strategies are termed search strategies and are found while creating a Position Search window. Using your assumptions for the future price direction of the underlying asset, OptionStation uses models that calculate theoretical values for option prices, volatility, and bid and ask prices. These are used to determine the theoretical profit and loss of the strategies you are considering. Models are also used by options traders to assess risk and determine potential profit and loss of option strategies under current market conditions as well as future combinations of possible market conditions.

In relation to the time value of an option, one must always keep in mind that they are wasting assets. From the moment you buy or sell an option, the time value of that option is decreasing. If you are the buyer of an option, this time decay works against you. On the other hand, if you are the seller or writer of an option, time decay works in your favor.

Options strategies use combinations of the four basic legs-long call, short call, long put, short put-to minimize risk and optimize the reward. Besides the frequently used strategies for trending markets, there are many that can provide profit in stagnant, sideways, and volatile markets. There may even be ones that may provide the potential for profit in markets where you are unsure of future price action.

Hundreds of publications have been written on option strategies, models, determining market direction, and options trading and analysis in general. We encourage you to research and use this information to better enable you to select the correct strategies, and to make logical and knowledgeable assumptions.

For information regarding the available models, see the Pricing Model Library, Volatility Model Library, and the Bid/Ask Model Library.