Options 101: How To Construct A Directional Play
When I identify an opportunity for a directional play, how do I decide:
a) what type of trade I want to do and
b) what strikes do I want to use?
Typically, with a directional play, I look for some sort of vertical. This lowers my cost basis (granted it caps my potential profit). But most importantly, I attempt to “target” a specific strike. I do this by “triangulating” a few approaches.
First, especially if it is a non-earnings play, I can identify support/resistance levels. Simply have your short leg of your vertical coincide with the technical level. But you can kind of throw out technical levels with an earnings report. The fundamentals far outweigh any support/resistance levels.
So, what to do? I have two approaches; one is to look at prior earnings performance. The past is not necessarily a predictor of the future, but it is an important piece of evidence, especially if the variance of the reports is low. So, if the average move of a stock is 5% and the past six are: 4%, 5%, 6%, 4%, 5%, 6%, this is much more predictive than one like: 0%, 10%, 0%, 10%, 0%, 10%.
My last (and strongest) piece of evidence is what are the options telling me what is priced into the market? Using the at-the-money implied volatility I can calculate what move is expected on a standard deviation basis. If the average move is 5% and the market is pricing in 10%, I cannot just ignore this. Someone at least thinks they know something and I have to adjust my risk tolerances accordingly.
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