The following is adapted from The Tao of Trading.
You’re new to options trading, excited to earn a great return, and familiar with the basics. But there’s still a question that makes you hesitate before pulling the trigger:
What stock option should you buy?
You know that you want to buy a call option when you expect the price to rise and a put option when you expect the price to fall. But, specifically, which call or put should you buy for the trade-in question? Fortunately, you don’t have to leave a choice like this up to a coin flip.
Here are two questions that will help you determine which option is likely to net you a higher return so you can make an informed decision.
Question #1: What Expiration Date Do You Want to Buy?
The first question you want to ask is “How much time do I want before the options contract expires?” Options lose value the closer they get to their expiration date an occurrence called premium decay-so you want to consider how much time you feel comfortable working with.
As a general rule, I look to buy options with at least twice the amount of time to expiration as I expect to be in the trade.
For example, if I expect to be in a trade for two weeks, I want to buy an option with at least four weeks until expiration. It’s always a good idea to buy yourself the luxury of time. I will often buy options with sixty to ninety days to expiration.
I recommend looking at the charted price swings of a stock you’re considering buying. Approximately how long does the stock rally for, before making another short-term top? Is it one week, two weeks, or three weeks? Whatever the approximate average period is, double it (at least) and that is how much time to expiration you want in the option you buy.
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Question #2: What Strike Price/Delta Option Do You Want to Buy?
The second question that will help you decide what option to buy involves the strike price/delta option. The strike price is the fixed price at which the owner of the option can buy or sell.
All options-both calls and puts also have a property known as a delta. Delta tells us how much we can expect the price of an option to change in response to a fluctuation in the underlying stock price. Specifically, delta tells us theoretically how much an option’s price will change given a $1 change in the underlying stock price. An option with a delta of 0.70 will experience a change in the price of $0.70 with a $1 change in the price of the underlying stock.
When buying calls, an option with a delta of approximately 0.70 (or delta 70) is always my starting point. These options offer a good balance between the cost of the option and the amount of extrinsic value I must pay for the option. Sometimes I will buy options with a delta of 0.60, sometimes 0.80, but 0.70 is always my initial go-to.
My other guideline for buying calls is I try to keep the extrinsic value down to roughly one-third of the total premium. For example, if the option premium is $3.00, I don’t want to pay more than $1.00 of extrinsic value if I can help it. For put options, I am a little more lenient. In the case of puts, I want the extrinsic value to be no more than 50 per cent of the total option premium.
Set Up Your Criteria for Buying
Deciding on an expiration date and delta for your stock options can help thin the pool of choices as you pick what to buy. I’ve shared my preferences for buying stock options, but yours may very well differ. You may be willing to take on more or less risk than me, and you can adjust your rules accordingly.
Above all, always look at the expiration date, delta, and other factors differentiating one stock option from another. You’ll make decisions based on data instead of guesswork and impulse, which will net you more consistent, lucrative gains.