In today’s option trading blog, I will assume that the market will find support at these levels and bounce. First I have to identify a core group of stocks that will participate. Then, I need to evaluate put writing opportunities. I have to take a look at each stock separately and formulate a game plan. Normally, I break my opinion down into direction, magnitude, duration and confidence. Each of these factors will determine my approach. Then I will need to evaluate the liquidity (bid/ask spread) of the options and the implied volatilities (IV’s).
In a sharp decline, all bets are off and I’m just trying to play it safe. My analysis will be more focused on stock support levels, option premiums, liquidity and fundamentals. When the world seems to be falling down around you and you are sticking your neck out, you’d better have conviction – you will be tested.
Here are two unique examples.
Stock A is fundamentally strong, support is a strike away, the premiums are relatively cheap and the bid/ask is wide. In this case I would be inclined to sell a naked put with the intent of owning the stock. I calculate the valuation ratios at the assignment price and convince myself that I would like to own the stock at that level. I don’t want to spread in this case because the bid/ask spreads are wide and I don’t want to pay $.40 ($.20 x $.40) for an option that is two strikes out of the money just to reduce my margin requirement and feather some Market Makers nest. The truth of the matter is that I want this stock. If I’m just “working” one leg of a trade, it is much easier to shop from one exchange to another. Also, if the position needs to be closed, I’m not fighting two bid/ask spreads on the way out.
Stock B is a good company that’s been on a nice run, has relatively high premiums, good earnings, fairly tight bid/ask spreads and it is a little less than a full strike out. Given the information, it’s safe to assume the stock probably has more downside risk at this level and is more volatile. In this situation I will be inclined to spread. I want to limit my risk, the position is more uncertain and I don’t feel like I’m getting ripped off by paying for an out-of-the-money OTM) option with bid/asks a mile wide. If the stock is showing real support I might consider a front month OTM option one strike out if I can collect at least a $1 credit on a 5 point wide spread for a stock that is $50 or more. If the support has not really materialized but I like the stock, I will probably opt for a 5 point spread two months out and two strikes out as long as I can collect $.80 or more. In this instance, I’m just trying to take advantage of a market related drop and I want to add probability to the equation. I remind myself that I’m early and the market may drop further. This is no time to get aggressive.
The price of the stock, the stage of the decline, the speed of the decline and a variety of other variables influence the trade. At this point I’m trying to identify opportunity and add probability to the equation.
The aggressive part won’t come until the market has confirmed a reversal. Remember that my search starts by identifying a rock solid stock, not rich option premiums.