7 Step Option Trade Entry Checklist
To complete our options trading course we'll walk through our 7 step options trade entry checklist that you can use as the basis for scanning and entering trades moving forward. Each step is put in sequential order on purpose so that you it helps you quickly move onto other trades if the current setup doesn't fit the entry checklist.
In this, the video was going to go through our 7 Step Option Trade Entry Checklist. Now, as we complete Track Number 2 here, this video is meant to bring together everything that we've talked about and be you easy to follow a checklist to ensure that your placing options trade correctly.
Remember we do have a downloadable PDF of this is you want to download this checklist and read through it in a different format. That is available for free here on Option Alpha.
Now, in our opinion this seven step order entry recipe, or checklist, or whatever you want to call it, is put together in a way that is logical in sequence, meaning one to seven, so that it gets you out analyzing trades that don't fit the requirements.
We put Portfolio Fit first because if it doesn't fit this requirement of being a good fit for your portfolio, you're out of analyzing the trade. If it passes Portfolio Fit, then you move on to Great Liquidity. If it fails that then out of analyzing the trade.
The whole goal here is to give you an opportunity to analyze trade quickly and move on from trades that don't fit or don't meet your criteria for entering a trade.
What we're going to do in this video is go through each of these with a couple of little examples to help bring everything together that we've talked about here in Track Number 2.
The first thing, like we said, is Portfolio Fit. This is asking you two questions, balance and then beta waiting. Like we talked about before, you talk about balance, meaning the number of bullish or the number bears trades you have, how many neutral trades do you have.
What is your overall balance look like? Are you over balance? Meaning you have too bullish trades. You don't have enough bears or neutral trades. What do you need in your portfolio to be as neutral as possible?
What we do at Option Alpha is we group our trades by different strategy types and also by different directions. You see that we also, we have our Iron Condors that we're trading right now, we have some Calendar Spreads that we're trading, we have one Call Credit Spread that we're trading.
You can group it however you want, that's just a quick little tip on how you can see balance. Maybe you group it by bullish or bearish or neutral.
Whatever works for you, but we do like to have, as we talked about previously, a lot of different positions that work in different ways, and also different positions that work well when implied volatility is high, or low, or all these kinds of different strategies that we can work at the same time.
Obviously the next important thing here is Beta Weighting. We went through an entire video training on Beta Weighting, but it's really important that you continuously try to trade as many uncorrelated assets and stocks as possible so that you're overall portfolio is beta neutral or delta neutral to the market.
There's a cool little-correlated asset table from Bespoke talking about the correlations between different sectors and industries, so you can see there's a high correlation between industrials and consumer discretionary.
High correlation there versus something that has very little correlation might be oil sector in the financials, okay, so very low correlation. Again, it doesn't matter, and this is such an important point, it doesn't matter what you end up trading.
You could trade all financials, or all health care, or all industrials, or whatever you want to do, just realize that the more you trade a broad breathe of securities, ETFs, and ticker symbols, the better off your portfolio is because you're going to have a lot of positions that are not correlated with each other.
Again, it all comes back down to just understanding that Beta Weighting aspect of it is "What is your overall portfolio look like?" Wherever you end up trading just make sure you Beta Weight your portfolio to some index on an ongoing basis so you know what you're looking for.
Number two in our seven step checklist is Great Liquidity. Now hopefully this goes without saying, but great liquidity means minimal slippage, so lots of volume on the actual stock, that's one thing that we can always look for, and then number two is lots of tight bid-ask spreads, even very tight bid-ask spreads far out of the money.
You can see at the time we did this screen shot with SPY even some of the strike prices that were far out of the money had two penny-wide spreads, one penny narrow spreads, so very tight bid-ask spreads in SPY. And it should be because this is a major market EFT.
This is in comparison to something like AVB, which we just randomly picked, but proves the point here where the slippage is incredibly high because it doesn't have a lot of volume and liquidity.
Notice that there's not a lot of volumes. There's practically no volume in open interest in either the calls or the puts on both sides.
As a result, you're looking at basically 50 dollar wide spreads, in some cases, which are for at the money options, which is incredibly wide. It means you're just going to lose a lot of money based on slippage alone.
Here at Option Alpha, we've already done the heavy lifting for you if you go ahead and purchase a lifetime copy of our watch list. We've already pre-screened, and continue to pre-screen on a reoccurring basis, the stocks and the options that have the highest liquidity.
That's all we look at, so that's why we don't have the functionality, nor do we want to put in the functionality, to search for different stocks that are off of our watch list.
There's generally around 100 stocks on our watch list at any given time, but things like Twitter, and GoPro, and SolarCity, and Linkedin, all of these stocks have incredibility high liquidity and their options are also very liquid as well.
If you to avoid the slippage, you can go out and look for it yourself and do the calculations and look at it, but we've already done, again, the heavy lifting for you.
Number three is Implied Volatility Rank or IV Rank. Now, again, this is a really important component that you know heading into a trade because it determines the type of strategy that you're going to select.
What's important here about Implied Volatility Rank is not the actual implied volatility number that you're looking at for whatever stock, it's asking you "Where is that number in it's historical range?"
If you're looking at Apple stock, for example, and we see that implied volatility is Apple is reading at 25%, we need to ask ourselves "Is 25% relatively low for Apple?" Maybe Apple usually trades with implied volatility around 75%, whatever the case is.
What we've already done is prebuilt our watch list here at Option Alpha. What you can do is you can come in here and sort my highest implied volatility to lowest implied volatility everything that we're looking at.
It makes it incredibly easy for you to see IV Rank of anything that's on our watch list with either high implied volatility or low implied volatility. It's all pulling in here for you at one time.
Number four is your Options Strategy. Now that we know where implied volatility rank is ... You can see why this seven-step checklist in sequential order ... Now we know where implied volatility rank is now we can determine the Options Strategy.
In my opinion, this becomes the difference maker between those who are successful trading and those who aren't is understanding which options strategies work best in which implied volatility markets.
Generally we want to be selling options when implied volatility is at the 50th rank. We want to be buying options, if we do, generally when option volatility rank is below 50, even towards the lower ends as a real kind of means to take advantage of low, low, low implied volatility.
That's the difference maker. Then, within each of those implied volatility ranks you could get more or less aggressive with your options selling.
As we've done here at Option Alpha, based on all the feedback that we get from our members, we have prebuilt in this ability to look for the best options strategies already based on implied volatility rank of whatever you're looking at at the moment.
For example, if you're looking at AXP for a trade and implied volatility rank is at 50 you know that the best options strategies are credit spreads, butterflies, or iron condors.
You can choose between those based on what you like to trade or what you understand to trade; it doesn't matter at that point.
Then if you scroll down and you see something with higher implied volatility, say you're looking at MON which has an IV Rank of 70, you can see that the strategies we can choose now depend on that implied volatility rank of IV 70, so the strategies include straddles, strangles, or iron butterflies.
As a final comment, obviously, we always include an IRA appropriate strategy for every level. You'll never be left out if you have a small account and you can't trade undefined risk strategies like straddles or strangles and you have to trade something with defined risk like an iron condor, or an iron butterfly, or a credit spread, or something like that.
The next thing that you do once you've determined which strategy you're going to select is determined strick prices and which month you want to trade for your contracts. This gets back down to this idea of pinning or anchoring your probability of success.
What we do here at Option Alpha, as we mentioned a bunch of times, is we build all of our trades to have about a 70% chance of success. So if we look at this trade, which is a trade that we have on at the time that we recorded this screen shot, you can see that we were trading SPY by selling a credit spread above the market.
When SPY was trading at 204, we sold the 208 209 credit spread. Again, at the time that had about 30% chance of being in the money. With a probability of being in money was about 30% that means that the probability of winning, or this trade being out of the money is about 70%. So that's where we target all of our trades.
If, for example, you want to be a little bit more conservative, and let's say you wanted to trade something around an 80% chance of success, you'd find the probability of being in the money at 20% or the Delta around 20 and that gives you approximately an 80% chance of being right.
Or let's say you want to trade something with a 90% chance of being right. So, again, you find the 10 deltas, where the 10% probability of being in the money, and that gives you about a 90% chance of being right.
Now you start determining what strike prices you want to be trading based on this idea of pinning your probability of success and continuously targeting this same likelihood.
Again as just another refresher, generally speaking as far out as you go, we usually like to do things with high implied volatility, so options selling strategies a little bit closer into 30 to 45 days, that's kind of like the sweet spot in range, doesn't mean that we'll always do things exactly between 30 and 45 days but that's the sweet spot.
When there's low implied volatility, we want to extend our trading duration, and want to trade things anywhere between 60 and 90 days out.
Again, that's not a hard and fast rule so just a general guidepost. You'd want to take advantage of that longer period to hopefully the stock swings into your range.
Once you've determined the implied volatility rank, options strategy, the strike prices and month, now we have to talk about Position Size. This is obviously something that we've talked a lot about here and, again, it critically important.
We use a sliding scale approach here at Option Alpha so for us to be able to make a lot of trades, which increases our chance of success, we need to make sure that our positions are so small that one or two trades that go very bad won't blow up our account because, remember, black swan events are going to happen.
There's going to be trades that go completely against you, and the only way to protect yourself is to keep your trade size small. Again, we use a sliding scale approach between one and five percent.
The only time that we'll edge towards 5%, and we rarely get towards that 5% level, is when implied volatility is high. When we have an insane amount of edge, theoretically with implied volatility so high, that's when we'll start to scale up.
But most of the trading that I do personally is on the small side with implied volatility, generally, even high, we still want to do our positions small so that the likelihood or the odds that our account blows up from one or two positions bad is really small.
So, again, we can use this sliding scale approach and our trade size, now location guide, to determine how big our position sizes should be.
If you're going to focus on each position being 2% of your account balance and you've got a 15 thousand dollar portfolio, then you need to make sure that you're taking on no more than 300 dollars of risk per trade day that your entering.
The doesn't mean that you can't do four or five contracts, it just means that all the contract for whatever symbol you're trading is no more that 300 dollars of risk. Again, if you're targeting a 2% allocation per trade.
The final thing that we have to talk about here, number seven, is Future Moves. Now, this is important because I feel like you should always be aware, but not attached, to something happening in the future.
So have a general awareness of what's going on. Don't live in the hole. Right? But at the same time, you don't need to follow the news each and every day.
Everything you need to know is already priced in. In a fair, efficient, liquid market, most of the news is already priced in.
Again, that doesn't mean that you'd need to be ignorant to the fact that jobless claims or unemployment is coming out and that might move the market, or the Fed funds, or earnings are on the horizon. Right? So just be aware of those types of things.
Another thing like we talked about, no when the earnings are. Know when dividends are. Know some of this kind of events in the future.
One of the cool things we've already build into Option Alpha is the ability to track and see when earnings are. For example, here with some of these stocks, you can see that we do have this earnings tag ... I just want to scroll down so you can see different ones.
But this earnings tag, if any stock has earnings coming up in the next 45 days, this purple tag will be added to the watch list. You can see PBR does not have earnings coming up in the ETFs, they obviously don't.
It just makes you aware of any possible earnings events that you can just know that it's on the horizon. Take a look at it and maybe make an adjustment to your strategy or not, it doesn't matter, but being aware, I think, is the most important thing.
So, congratulations on completely Track 2. That is the Seven Step Entry Checklist. Thank you so much for taking the time to go this. I hope that Track 2 was helpful in getting you over the hump, from becoming a beginner to becoming, now, a little bit more professional in how you approach your options trading.
As we get into Track Number 3, or as you move on to Track Number 3, we're now going to take everything from beyond order entry. So Track Number 2 here was designed to get you all the way up to placing and entering trades.
Now Track Number 3 is going to take everything beyond that which is managing trades, exiting trades, adjusting portfolios and trades, managing yourself as a professional trader. Again, hopefully, this has been incredibly helpful for you.
I'd love to hear your comments and feedback. If you love it, please let us know. Please share these videos online with your friends, family, co-workers. Help spread the word about what we're trying to do here at Option Alpha and until next time, happy trading.
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