Before we can make money in the options market, we have to locate an opportunity, writes Russ Allen of Online Trading Academy, and here he outlines the process step by step.
There are many ways of identifying opportunities. In this two-part article, we’ll discuss just one of those: look for stocks/ETFs whose options are extremely expensive, and sell those options.
This sounds pretty straightforward, and it is. But several steps are involved, as listed below. We’ll use an example to walk through the steps.
Locate stocks with currently unusually high implied volatility (relative to their own IV history). High IV means expensive options.Check the stock’s price chart and decide whether it is a bullish, bearish, or neutral picture.
Select an option strategy to match the price outlook—iron condor if neutral, otherwise short options or credit vertical spreads.
Select strike price(s) that the stock is unlikely to reach by the front-month expiration date, and plan the trade.
Calculate the underlying prices for maximum profit, maximum loss, and breakeven. Use option diagramming software to facilitate this.
Identify the stop/unwind price(s), where the trade will be abandoned for a loss if necessary.
Evaluate the likelihood of stock being in the profit zone at the target date.
If all looks good, place the trade.
Once the trade is in place, enter the order(s) to unwind it when/if the underlying hits the stop/unwind price(s).
Now let’s look at an example from July 17:
1. Locate stocks with high implied volatility (relative to their own IV history)
For this step, I used the scanner tool in the TradeStation software platform. That is the trading software that we use in our trading classes, and is also the software that I use for my own trading. One of the scan criteria TradeStation offers is called “IV Percentile (12 month).” Using this criterion and asking for the top 10% of stocks by IV percentile, and further filtering the list to eliminate stocks with a daily average volume of less than one million shares or a price of less than $15, produced a list of about 50 stocks. Each of these was near its highest implied volatility level of the last 12 months. Outside of the TradeStation platform, most other option-trading platforms, such as thinkorswim and OptionsExpress, also offer some kind of screening by implied volatility. Other sources for such scans are also available online, although none is free as far as I know. On this day, one of the stocks my scan turned up was American Tower Corp. (AMT).
2. Check the stock’s price chart and decide whether it is a bullish, bearish, or neutral picture.
Below is AMT’s chart. The stock was near the middle of a channel between roughly $70 and $80, in which it had been trading since May 31. The channel boundaries appeared to be good demand and supply levels. This was a neutral price picture—one where we could bet that the stock would stay within a range, for a limited time.
Figure 1 – AMT Price chart as of 07/17/2103
NEXT PAGE: Match Strategy with Price Outlook
