The Best Option to Trade

I was recently asked how I select the best option to trade. There are hundreds of options with strike prices ranging from 250 to 700 on the SPDR S&P 500 ETF (SPY). How do I select one over another?

1. Under normal conditions, the best balance between risk and reward is the “at-the-money” options, which are the next level off the strike price. In other words, if the stock is trading at $526.60, I will normally look at the 527 strike for calls and the 526 strike for puts.
2. If I suspect the stock will move significantly, likely off a significant news item, I may look at further “out-of-the-money,” cheaper options as they would have a greater percentage gain should the stock make that anticipated move. They are also riskier as they stand to lose their premium if the underlying asset fails to move.
3. If the market has not yet opened, I will look for a high open interest, suggesting that those options are widely held and have greater liquidity. When the market opens, I flip over to the volume, looking at where most of the activity lies. High volume is like fishing where the fish are; your likelihood of snagging a winner is much greater. It also means the bid/ask spread is tighter.
4. Ideally, selecting a higher delta is preferable, but balanced off against the price of the option. Higher delta pushes strikes more “in-the-money”, and greater premiums. If I invest heavily, I likely would trade slightly “in-the-money” with a greater delta, which would also facilitate a still respectable strike should the stock price slip away from me.
5. Theta loss is also essential in that the lower, the better. For that reason, I like to have ample time to expiration. Usually, I will trade the same week’s Friday expirations on Mondays and Tuesdays, and the following week’s Friday expirations if it’s a Wednesday through Friday. This gives me sufficient time for the options to mature organically to profit without losing much time. For aggressive trades, same-day expirations are referred to as 0DTE. Only experienced traders with a clear understanding of the risks of high volatility and frequent trading should embark on this strategy. Also, ensure that your broker can facilitate 0DTE transactions.

Before randomly selecting options — perhaps the deep “out-of-the-money” calls, for example — study the option chains. Note how far out the greater open interest lies. Study the day’s highs and lows. As I write, the market is closed, but SPY last traded at 526.41. The “at-the-money” call option I would typically buy now if the market were open would likely be the 530 calls with seven days to expiration. It is several strikes away from the current price but has a higher open interest at the 550 level, a whopping 23 strikes off the current price. The open interest is over 10,000, significant volume on yesterday’s trades, and the option price is .76/.77 with seven days to expiration. It also had a low of .59 and a high of 1.27 yesterday. If I felt confident the market would rise in the next day or so, I would take this opportunity. Two strikes further out, the 552 calls had similar data, holding at a cheaper price of .52/.54. A trade of 100 contracts would have cost $5,400 but had a potential of 113% between the high and the low.

Understanding options takes time, and the wise trader will invest the time and effort to determine the best options to trade. These are just some of the things we discuss in the Trading Room. Veteran guru Jon Johnson and I take you through from analyzing market fundamentals to successful option trades.

As a new trader, you may also want to be given a particular option to trade. Check out our DTS Signal and Pick of the Day, two outstanding services with excellent performance. These are specific options sent to you on a timely basis for you to take a look at. You can even trade these on your phone app. Click the links for details.

All traders should subscribe to our Inner Circle, where we send you our opinions on the market before the opening bell. Let us do the heavy lifting so you don’t have to.

At the very least, spend an hour or so with us Sunday nights at 8 p.m., ET. Our Intro to Trading/Week in Review is informative, engaging and, some say, even entertaining.

Create great trades!

Hugh