Don’t let yourself be overwhelmed by the options.

When choosing a stock to purchase, you probably look for a company with growth potential or a strong financial outlook — a company whose stock price you think will increase over time or one that will pay regular dividends.

But as an options investor, you might be looking for a company whose stock price will rise or one whose price you think will fall in a finite period.

What’s important is that you correctly predict whether the price will rise or fall, and by how much. Buying stock also allows you a virtually unlimited amount of time to realize a price gain. As an options holder or writer, however, you need to be accurate in your prediction of the speed with which the stock price will move, as well as how far and in which direction.

Selecting the Right Security

Doing options research

There’s no one best research method for choosing a security when trading options any more than there is when trading stocks. You might prefer a technical analysis, which emphasizes an assessment of price trends and trading patterns in market sectors or overall markets, or consult a fundamental analyst, who studies the particulars of a certain company.

For example, Investors A and B are both interested in the stock of corporation XYZ. They know that a quarterly earnings report will be released in a month, and they’d like to predict whether the stock will rise in response to a good report, or fall in response to low earnings — though, of course, it could do something they don’t expect. They both conduct further research. Investor A prefers technical analysis, and looks at statistics such as the market’s moving average and the recent performance of XYZ’s sector, in order to gauge the overall outlook of the company.

Investor B, however, relies on a fundamental analyst who looks at XYZ’s recent product launches and analyzes the performance of its CEO to predict the nature of the earnings report. Both Investor A and Investor B could use their research to estimate whether the earnings report will be good news, neutral, or bad news for XYZ, and whether stock will rise or fall in the months after the report’s release. How you apply your research will depend on your style of analysis, as well as your own experience with investing, your knowledge of the stock market, and your intuition. Many experts recommend that you use elements of both technical and fundamental analysis when researching an equity, to get a balanced perspective.

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Accepting the risks

No matter how well you’ve researched the equity on which you buy or write an option, there’s no guarantee that your trade will be successful. Some advisers recommend that you consider the probability of the success of a particular trade. Probability is a measurement of the odds that you’ll achieve the goal behind your options strategy, which might be making a profit or purchasing stock, for example.

Moreover, probability is based on factors including volatility, since an out-of-the-money option on an underlying instrument with high volatility — or one that often changes in price—is more likely to move in-the-money. It’s important to estimate the probability of success before committing yourself to a trade. You’ll have more realistic expectations and a better sense of what you stand to gain and to lose.

Managing your cash

How you’re going to manage your capital is another important decision to make before you trade options.

  • If you’ve already allocated all your investment funds to other types of securities, you’ll have to reallocate in order to free up capital for options. Most experts recommend that you use options to complement a diversified investment portfolio instead of dedicating your entire trading capital to options.
  • If you’re not very experienced, you might consider trading options with risk capital only, or money that you could tolerate losing entirely, particularly when purchasing simple puts or calls.
  • You should also take into account the impact that trading options on margin will have on your cash allocation. If you write an uncovered call, you’ll have to deposit a minimum percentage of the value of the underlying shares into a margin account with your broker. This might mean tying up funds that you would have invested elsewhere.

How To Select The Right Security For Options Trading? by Inna Rosputnia

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