My Rules for Choosing Underlyings

In August I wrote a post on selecting underlyings for options trading and in this post, I will explain in more detail which specific rules I use for choosing underlyings for my options trading.

Choosing the right underlying is a very important element in constructing a trade. And for being successful and reaching your goals in options trading.

But before you do that I first created a list of favorite underlyings. I want to keep this as small as possible, so I can really get to know the companies or funds or indexes behind the underlyings much better. It is impossible to follow the whole market, and I still have other jobs and projects to do, so my list of ‘faves’ is limited to not more than 15 symbols of companies and funds I already know or can focus on to get to know better.

So how do I select those underlyings on this list? What construction tools do I use, where do I look and what criteria do I use?

Selecting a Group of Underlyings to Trade With

I follow the guidelines very much described in one of my favorite books on options trading by Tastyworks‘ Julia Spina:

Liquidity of Underlyings

The best underlyings to trade with are optionable stocks, ETFs, or indexes that have all or as many as possible of the following characteristics traded in highly liquid options markets (that is: easily convertible into cash without affecting the price):

• High liquidity as underlying should offer: high daily volume; I aim at > 1 million shares traded daily
• Tight bid-ask spread: not more than 0.1% of the asset price as the difference between what the buyers are willing to pay and what the sellers are willing to accept.
• Flexible/multiple open interest and time frames to choose from (also for managing positions!)
• High liquidity in markets: the options should offer :
  • high open interest or high volume across strikes; I aim at > 100 (preferably a few hundred) per strike
  • tight bid-ask spread; I aim at <1% of the contract price

Selecting the Right Underlyings to Trade With

The next step in constructing the trade is choosing the right underlying to trade with.

Capital Requirements of Trade

I use the following conditions when choosing the underlyings:

• The underlying should cost no more than $200 (so that if things go terribly wrong I can still cover it with my capital and sleep comfortably at night) and not less than $15
• A single position generally occupies no more the 3% to 5% of portfolio capital
• Occasionally I can go higher since I still have a small account but not higher than 7% if I want to sleep comfortably)
• The larger the account the lower the percentage of portfolio capital can be (going down to 1%),

Types of Underlyings

At this stage, I only look at stocks and ETFs. Not indexes, mainly for the reason that I believe my account size is too small to already traded the higher numbers related to the most liquid indexes (SPX, etc.).

Stocks

Stocks offer higher volatility conditions and better credit and profits opportunities, but the risks are higher (profit/loss (P/L) swings during trade, ending P/L changes, more tail risk) since it is only one company, earnings and dividends can cause big shocks and buying power reductions are higher. Based on my selection criteria I found the following selection of stocks to choose underlyings from:

• C – Citigroup – the financial services holding company – sector: Financials
• LYFT – Lyft – a peer-to-peer marketplace for on-demand ridesharing in the US and Canada – sector: Business Services
• MRO – Marathon Oil – hydrocarbon exploration and international gas operations – sector: Energy
• NIO – NIO – smart electric vehicles in China – sector: Motor Vehicles
• PLUG – Plug Power – clean hydrogen and zero-emissions fuel cell solutions – sector: Machinery
• RIOT – Riot Blockchain – bitcoin mining operations – sector: Computer Processing Services
• SNAP – Snap – mobile camera application – sector: Computer Programming/Software Services
• UBER – Uber – mobility as a service provider – sector: Business Services

I will need to see whether I need to create more diversification. At this stage green car services solutions and technology seems to be overrepresented.

ETFs

ETFs (Exchange Trade Funds) inherently offers a diversification in a sector (multiple companies) and in general have lower volatility profiles, but they also often have lower buying power requirements. I still managed to find around five ETFs to focus on:

• EWZ – iShares MSCI Brazil
• FXI – iShares China Large-Cap
• GDX – VanEck Gold Miners
• IWM – iShares Russell 2000
• SLV – iShares Silver Trust

Here I think I may need to make a choice between SLV and GDX and since silver according to me has much more utility (in technology) than gold (only emotion), I am thinking of dropping GDX.

Also. IWM is close to $200 and is by far the most expensive underlying I have in thet list. The rest is below $50.

Events

I also base my selection (especially of stocks) on events like earnings, dividends or company announcements. My rule is that I stay away from taking on new positions a few days after earnings or dividends or that have such events occurring before the date I want to close the position.

In general I use 21 days DTE for closing positions. If earnings or dividends fall before or on such date or within 7 days after such date, they will be de-selected.

I do however plan (and have already started) to also study what is called ‘earning plays’

In Tastyworks and other platforms, you can configure a watchlist that gives you a quick insight into the liquidity of your underlyings. ‘Vol’ is here the cumulative trading volume for the day.

Weekly Selection of Stocks /ETFs to Focus On

Based on the above I each week check my open positions and look for new options ideas based. I use different tools to come to my selection.

Tastyworks – IVR

Firsty, I look in Tastyworks at my ‘Faves watchlist how IVR, IV%% are doing.

I then also look at future events like earnings and dividends that may limit my list to trade with for the next week.

Options traders should pay very close attention to stock-specific events.

Such events before they occur, can have a huge effect on implied volatility (IV). IV in turn can significantly impact a stock price . Identifying upcoming events that may impact an underlying asset or stock price will help me decide on the right expiration or time frame for my option trades.

All this should already reduce the list to not more than five underlyings.

TradingView, BarChart and Lookback for Technical Analysis

I then check the hitorical data and charts of the underlyings. I also look at different periods, like short term (last few days), medium term (e.g. two to three months) and long-term (one year).

After this, I check whether I can identify patterns and trends, and whether the underlying is in an accumulation, advancing, distribution or capitulation phase. My main tenet is to follow the trend.

TradingView, BarChart and backtesting software like Lookback, I also look at historical data and charts to identify trends for the specific underlying.

Although past performance is not indicative of future results, looking at a company’s historical stock performance is still very useful and is highly recommended if you have the tools or resources to do so.

I can review historical prices to find support and resistance levels, or determine a company’s valuation and growth potential.

TradingView

TradingView is an ideal platform for technical analysis.

Barchart

I use BarChart’s screeners with the following indicators to follow my selection of underlyings.

• Weighted Alpha
  • Measures stock price movements over the course of (typ.) 1 year)
  • Values are weighted to emphasize more recent price swing over less recent ones
  • Use $VLA (Value Line Index) and assess how other symbols on list perform against it
  • Try to find stocks that have higher weighted alpha
• Barchart opinion
  • ‘Today’s overall opinion = overall average signal calculated from all Barchart tech indicators
  • ‘signal strength’ = long-term measurement historical strength signal
  • ‘signal direction’ = short-term (3-day) measurement signal movement
  • Try to find stocks with at least around 80% technical buy signal
• 50-100 Day MACD Oscillator Opinion
  • MACD (Moving Average Convergence/Divergence)= similar to ‘line oscillator’
  • Uses exponential moving averages (vs simple moving averages -> buy/sell indicators are identical)
  • Where 50 and 100 day MA cross = longer term indicator -> trading signal
• Trendspotter
  • Attempts to find general trends for specific markets
    • When there is a single dot above the price, this is a resistance point and represents a bearish trend.
    • When there is a single dot below the price, this is a support point and represents a bullish trend.
    • When there are 2 dots, one above and one below the price, this represents a neutral or hold trend (these are the entry prices to make a new buy or sell trade).
    • When a trend EXITS either a bullish or bearish trend, the trend is forced as a neutral trend for at least one day.
• Number of new highs in the last month
  • the number of times in the last month that a stock hit a new high.
  • since there are 20 or 21 trading days each month, I like stocks that have hit new highs in at least 50% of the current trading session, or at least 10 days.
• Final test
  • look at a chart where 20, 50 and 100 day moving averages with the TrendSpotter.
  • Hopefully, it is a stock where the price has a 1-to-1 slope and the price, 20, 50 and 100 Day Moving Averages never cross. 

My checklist Barchart should give me answers on the following:

• Are there 100% technical buy signals?
• Is Weighted Alpha positive?
• Any positive gain in the last month?
• Is there a Trend Spotter buy signal?
• Is the underlying above its 20, 50 and 100 day moving averages?
• Are there new highs and up in the last month?
• What is the Relative Strength Index?
• What is technical support level at ? (use support ‘areas’ for expensive stocks)
• At what level did it recently trade with a 50 day moving average of how much?

Lookback

Tastytrade’s Lookback and the historical data in that platform is what I use for backtesting ideas. It also uses Monte Carlo simulation to predict the future!

WallStreetZen/BarChart for Fundamental Analysis

I follow the underlying in WallStreetZen and BarChart. Here I can find announcements, what analysts think of the stocks or ETFs, whether there is insider buying or selling, etc. I use Google Alerts to receive latest news.

I can also find detailed financial information (PE etc).

The same I can do in BarChart:

SEC Filings (EDGAR)

Escpecially for 4K or 10K filings

I can also use BarChart here:

The Company’s or Fund’s Website

Check the website. By law there must be a section on the company website that provides information on the business or fund.

The key details on the company’s website are:

• significant shareholders and the breakdown of the shareholder register
• directors of the company
• the annual report.

Therefore, monitoring a company’s official web site where you might find lots of useful information, including press releases, planned events and company news is recommended. Also monitor stocks actively discussed in forums and message boards.

Conclusion

Selecting the right underlyings I am going to trade with at the right time and for the right reasons is an important element in becoming successful.

Choosing a selected group of underlyings based on daily volume, liquidity, tight bid-ask spreads and availability of multiple contracts (strike prices/expiration dates) is the first step.

The next step is selecting from this group the underlying to trade with this week based on buying power reduction versus account size, the implied volatility, the extent to which I can stand P/L swings, and tail risk, and events that can influence my trade (earnings, dividends, announcements).

The next four steps to construct a trade consist of selecting a contract duration, choosing a defined or undefined risk strategy, a directional assumption, and finally, selecting deltas.

They will be further discussed in my post on how to construct an options trade.