Chapter 8: How to Choose the Right Instruments for Options?

Once you develop a view, based on your trading plan, a trader needs to  choose the right instruments to go ahead and deploy the strategy.

In the world of options, there are endless possibilities for a trader to enter into a trade as there are thousands of strategies that use different instruments to create the same desired output.

For example , if a risk-averse trader has a bullish view and therefore decides to  take a bullish position has 2 choices.

Take a bullish position by buying a call option or also sell a put option. Buying an option has limited risk and unlimited profit potential but selling a put option has the exact opposite risk-reward ratio.

For a trader who is risk averse, taking a  bullish position by selling a put option would not make sense as the risk of selling options may not suit his ability to manage his risk.

Besides,  there’s a high chance if there is high volatility in  the markets, higher fluctuations may bring fear onto a traders mindset and the trader would exit the position in spite of having the desired results.

Thus, choosing the right instrument in options trading is the most important.

Things to keep in mind while choosing instruments in Options Trading:

1. Underlying Asset

Understand the underlying asset that the option is based on. It could be a stock, index, commodity, or currency.

Make sure you’re familiar with the market dynamics of that asset and any potential events that could impact its price.

2. Liquidity

Choose options with sufficient liquidity. High liquidity means there are more buyers and sellers in the market, making it easier to enter and exit positions without significantly affecting the option’s price.

If a trader is trading bigger position sizing, then the trader  has to ensure that there’s enough liquidity in the strike price chose to trade with. Low liquidity could result in higher impact costs.

3. Strike Price Selection

Depending on your strategy, select strike prices that align with your outlook on the underlying asset’s movement. Different strike prices can offer varying risk-reward profiles.

For example, the strike prices closer to the spot prices of the underlying asset (ITM and ATM), will have higher volatility as compared to the strike prices which are far way or Out of The Money (OTM).

A trader should ensure that the strike price chosen is aligned with the risk that the trader is willing to bear with. 

4. Expiration Date of the Contracts

Consider your trading timeframe and strategy when choosing the expiration date of the option.

Short-term traders might prefer near-term expirations, while long-term investors might opt for options with more time until expiration.

This is  because as the options come closer to their expiration date, they tend to become more volatile and also theta decay is the maximum as the contracts come closer to expiry.

5. Impact of Implied Volatility on Option Premiums

Implied volatility reflects the market’s expectations of future price movements.

Higher implied volatility generally leads to higher option premiums and vice versa.

Depending on your strategy, you might prefer higher or lower implied volatility.

6. Strategy Alignment with Risk & Reward

Ensure that the options you choose align with your trading strategy. Different strategies, like covered calls, protective puts, straddles, and spreads, have varying risk-reward profiles and require different market conditions to be effective.

Thus, a trader has to ensure that the right strategy is deployed at the best possible time , for better chances of success.

7. Risk Tolerance

Evaluate your risk tolerance before entering any options trade. Options can magnify gains, but they can also lead to significant losses. Only trade with money you can afford to lose.

Risk can be quite subjective. That’s why it’s important for every trader to evaluate their own risk tolerance and choose the strategy and the right instruments that suits them the best.

8. Market Outlook

Have a clear view of the market’s direction. Are you bullish, bearish, or neutral? Your outlook will influence the type of options you choose and the strategies you implement.

9. Risk Management and Hedging

Although there’s no such thing as a perfect hedge, option traders can experiment and choose the best possible combinations of options to get the desired outcome.

11. Practice and Paper Trading

If you’re new to options, consider starting with paper trading or using virtual trading platforms to practise your strategies without risking real money.

Remember that options trading carries a level of complexity and risk, so it’s important to thoroughly understand the concepts and strategies before diving in.