Once you start looking for option trades on your own, the most important thing you can do to find trades with triple-digit profit potential is staying up on the news. The market and stocks in general move up and down over time, and the key is to identify these cycles.
You will learn to decipher information in the articles you read or the shows you watch to form your own opinion. For every Wall Street analyst who likes a stock, there’s another who hates it.
As part of this deciphering process, the first thing you have to do is categorize the news as bullish or bearish. If it’s bullish, you may want to buy calls. If it’s bearish, you may want to buy puts.
After deciding if you are bullish or bearish, the next step will be to look at a historical chart that analyzes that stock over a period of at least one year or longer. If shares are trading near a 52-week high, ask yourself what seems to be driving the stock higher and whether it can continue to climb?
In contrast, if a stock is making new 52-week lows, you know there might be a problem with the company.
This is where you want to target your option trades. You can always trade the “ranges,” but your best profit potential lies in stocks that are breaking out or breaking down. Oftentimes, these moves coincide with big news events about a company.
Earnings announcements are also great setups for big changes in a stock’s price, but there is more risk to these types of trades. The bulk of earnings announcements hit the market in mid-January, April, July and October, and the results directly impact stock share prices. Companies are also expected to provide their outlook for the coming quarter or the coming year for their business. However, sometimes they don’t because of the current economic climate.
Don’t assume that if earnings are higher, the stock will trade higher. And don’t assume that if earnings are lower the stock will trade lower. If a company’s earnings don’t quite measure up to Wall Street’s expected numbers, it is still possible the stock can trade higher. Predicting the right option trade on an earnings announcement is an art.
Another good way to digest market news is by following upgrades and downgrades of a stock. When a Wall Street analyst makes a recommendation or changes the rating of a stock this is called an “upgrade” or “downgrade.” A stock’s share price can move substantially when this happens. Upgrade and downgrade information is available from most financial websites. The total number of analysts who follow each stock is also listed.
The most common stock rating labels are “buy,” “hold” or “sell.” Sometimes you may see “strong buy” or “strong sell,” or “overweight” (bullish) or “underweight” (bearish).
When it comes to the stock market, I’m both bullish and bearish. I talk about momentum all the time because it is important to know which side has it. If you are a bull, then you want the market to rise, and you tend to favor call options on stocks. If you are a bear, then you are hoping the market will trend lower, and you favor buying put options.
It is no big secret, but it’s still worth noting: Knowing which way the market is headed and which side has momentum is crucial in determining if you should buy call or put options. It is hard to make money when the market is setting new highs, and you have a rack of put options in your account. The opposite is true if the market is headed down and you own call options.
Because options are time-sensitive, you have to look forward in your trading and try to figure out where the market will be by the time the options you are considering are set to expire. You also have to give yourself enough time for the trade to work in your favor.
These are just some helpful tips to improve your option trading strategy. You should also have a balanced portfolio and only trade a fraction of your portfolio with options, as the risk is much higher. You can also sell options on stocks you own to collect income and to reduce your cost basis. This is known as covered call writing.