As an options trader, selecting the right underlyings (stock, ETF, or index) to trade at the right time is extremely important for reaching my options trading goals. In the past few months, one of the reasons I have been struggling in my first options trades is selecting the wrong underlying stocks or timeframes to trade.
So, I need to step back and do some research in choosing the right basket of underlyings to trade with. And then, I need to determine which underlyings I should select to set up profitable options trades.
Finding the (entries to the) right trades I will write about in another post.
Before focusing on what options to trade, I need, first and foremost, to determine which stocks, ETFs, or indexes to trade. I need to know the companies, and the funds behind the ETFs, the basket covered by the indexes, etc.
Fundamental analysis and reading earnings reports is an important part of determining the underlying portfolio I am going to trade with. For stocks, I research the management teams of companies that I want to invest in, visit their websites and read their press releases, look at the products or services they provide, the countries they operate in, and how the market sector they’re part of is doing. I use WallStreetZen for this.
Since I don’t have time to follow many underlyings, I limit myself to following around 10 stocks, funds, or indexes per week. This may still be too high, so I may have to reduce it.
Once I have selected an underlying, I need to look at it individually. I not only have to be correct on the price movement of a stock, or another underlying asset. I must also be right in predicting when price movements will occur. For this, I need to use some amount of technical analysis. Both TradingView and BarChart have all the tools I need to do technical analysis.
Also, I research past and upcoming events that might impact(ed) stock and options prices (esp. dividends and earnings). Events such as economic data releases, federal reserve announcements, election results, economic data releases, earnings reports, and product launches can have a significant impact on stock prices.
In addition, monitoring underlyings actively discussed in forums, message boards, etc., and further research and analysis are necessary if I want to consistently find the right stocks to align with my options trading strategy (playbook).
All this should dramatically increase my chance of trading options successfully.
So, how do I select my stocks for options trading?
Finding The Right Stocks
In trying to find the right underlying stocks, ETFs, and indexes, I focus on the following criteria:
- The last price of the underlying must be between around 20 and 200
- I only choose liquid stocks to invest in
- The average 50-day volume should be above 5 million
- In Tastyworks, the underlying should have four stars for liquidity
- The underlying should be reasonably volatile (IVR >40%)
Underlyings between 20 and 200
I focus on medium to higher-priced underlyings with strike prices not lower than 20, since the premiums are not interesting anymore below this number, and not going much higher than 200 to stay within the boundaries of my max loss allowance.
Also, medium or higher-priced stocks usually offer a good range of movement (volatility), which can have a positive impact on my options trading strategy. It will be easier getting in and out of a trade, covering my fees and commissions, and earning a profit.
Choosing Liquid Underlyings
In selecting the underlyings to use for your options trading strategy, it is essential that I can choose from a pool of highly liquid stocks. Liquidity allows me to get in and out of a trade more easily without losing too much money.
The most liquid stocks are usually those with higher volumes. In the first year, I will use only a very high volume for trading. At least around 10 million average daily volume to cut out unpredictable and counter extreme speculative thinly traded stocks.
Increased Implied Volatility
Since my options strategy is mainly based on short premium trading, volatility of underlyings is very important to me when choosing stocks, funds, or indexes to trade options with.
I try to find stocks that are somewhat volatile with a higher average daily range (ATR), of more than just $1. I check the high-low ranges of the market leaders or of the underlyings I’m interested in trading.
After a period, I need to come back and see whether the range is wide enough and whether the range occurs regularly, to keep trading the stock.
Implied volatility is, in essence, telling me whether the (future) market is expecting a stock to move a lot or not. With higher volatility comes higher premiums which make selling (‘writing’) a call more attractive, assuming the volatility will not continue to increase to the point of causing the option to be exercised.
On the other hand, lower implied volatility means cheaper-priced options, which benefits the buyer of the options if a trader believes that the underlying stock will move enough to finish further in the money.
I also compare an underlying’s historical volatility with its implied volatility to get a broader picture of what to expect. I watch for any major events that could affect the implied volatility of my underlyings and/or significantly affect the stock price.
In selecting underlyings I try to diversify by including multiple sectors or industries in my portfolio. This will help avoid having too much invested in one sector.
I want to have at least five sectors represented. Also, no one sector should represent more than 25% of the portfolio.
In addition, no one position should be risking more than 2% of TOMIC’s capital.
For example, I could have options positions in five markets, such as SPY, GDX, BAC, IWM, and BP. This mix will create good diversification.
What about sector rotation? I do keep track of the major market sectors, but I need to read more about cyclical investment strategies and whether it will help me select the right underlyings or to be more profitable in options trading.
Choosing My Ten Underlyings and One ‘Guilty Pleasure’ Stock
I keep track of my top ten underlyings to trade within Excel using the Data > Convert to Stocks functionality provided nowadays in Excel. It allows me to automatically fill a table with all the data I need related to a company, fund, or index, including prices, price changes, high-lows during last 52 weeks, fundamentals, when applicable, like market cap, EPS, volume, average volume, etc.
My ‘guilty pleasure’ is the last one, RIOT, that I separated from the list since it doesn’t fulfill all requirements defined above. In addition, it is hard to borrow.
RIOT, a blockchain stock very much correlated with (actually, at this stage, fully dependent on) the success of Bitcoin. I have followed everything related to crypto, NFTs, and the underlying blockchain technology. So I have gotten to know this new sector and, in particular, RIOT quite well. Very volatile, and very high risk, but until now, my trades in RIOT have been quite successful. It shows that knowing the sector and industry and the different players and triggers affecting stocks and other underlyings is crucial.