Lesson Overview

Strategy Selection Process

The process of selecting the correct option strategy is all about elimination. Eliminating strategies that do not work for that current market set up regardless of how good that might seem at the time to use. We have already put together a comprehensive strategy guide that you can use and this video will be a complement to that physical strategy guide as a way to help you understand how to narrow down the best strategies to use for any possible set up. A slightly longer tutorial, this video will help go through multiple examples and many different market scenarios as well as the possible strategies using our three-step system.

Show Video Transcript +

In this video tutorial, we’re going to show you guys how to select the best option strategy for any stock or trade that you're looking at.

I often find that people really think this is more complicated than it ends up being and you get into this analysis paralysis of which strategy do I choose and it’s really actually an easy process that we’ll go through here using our strategy guide right inside the membership platform.

The first thing that you’re going to want to do is just click on the strategy guide icon here and that’ll take you to the strategy guide page in Option Alpha.

Alright, once we’re on the strategy guide page here, you can see that it's a very simple page, but don't underestimate the simplicity of it for how powerful it can be in helping you create and select the right option strategy.

It all starts with a simple three-step process and the first step in this process is you have to have some sort of directional assumption in the underlying stock or ETF. Are you bullish, bearish or neutral?

And frankly, it really doesn't matter because at the end of the day, we’re going to be 50/50 in our bets. If we’re betting a bunch of times bullish or betting a bunch of times bearish, we’re going to be no better than 50/50.

But the whole assumption here is that you have to have some hint or guess or gut feeling as to where the stock may go in the future. You can throw in some technical analysis if you want to use that or fundamental analysis at this stage, but it's really important just to pick a direction and move on.

Step number two is the most important step and this is a step that people often miss or don't even do at all. This is all about figuring out where implied volatility is for that individual stock.

Here at Option Alpha and at a bunch of other places that do very well successfully trading options, we use IV rank or IV percentile and that's basically a complicated way of saying that we look back in time and say, “Okay, based on implied volatility going back the last year for this stock, is the current reading in implied volatility relatively high or relatively low?”

It gives us an idea of where implied volatility is going back historically for that stock, so that we know, is it going to revert back to the mean and drop or is it going to possibly rise in the future.

This gives us the best edge that we can possibly have in the market because then, we are able to trade the right side of implied volatility and stock direction becomes less and less important as we get implied volatility more and more right.

Step number three is then just choosing a strategy from what's left. After we have eliminated things in step one and step two by choosing the right side of volatility and by choosing which directional assumption we have, then we’re just left to pick from a couple of different strategies that we have chosen.

There’s obviously other strategies out there, but these are the ones that we use most often. Let’s go through a couple of examples.

Here’s what it looks like. As you scroll down this strategy guide, we have the directional assumption on the left hand side and then you can see as you go down, we have neutral high IV rank and then we have a bearish high IV rank and low IV rank.

It’s all in here for you, so you just have to go through the process here of going through step one, two and three. In this case, let’s start off with Google. Google is a really good example of this.

We can just go through a bunch of different securities here and try to make sure that you guys understand how this all works.

With Google, the stock is currently in a downtrend, and it’s been in a downtrend for the last about a month and a half, and you can see it’s been in a longer term downtrend even than that.

But the short-term trend has been lower for sure and implied volatility is currently sitting at the 56th percentile. What this is saying is that if we go back over the last year, Google’s implied volatility, (and we chart it) there’s about a 56% chance that it will be lower than it is right now in the future and that’s on average.

We can say that implied volatility which is sitting right here at the 56th percentile is over that 50th percentile that we use, and therefore, it becomes relatively high implied volatility.

If we’re directionally bearish on the stock, we think the stock might continue lower, and implied volatility is relatively high; now we have the two ingredients that we need to go back to the strategy guide and choose the different strategies that we want to select from.

We’re not going to choose the bullish section, so we’re going to keep scrolling down past that. We’re not going to choose any neutral because we’re not neutral on the trade and we’re finally going to end up here with the bearish section.

We are bearish on the stock. That's good. Then you can see we have the choice. Are we in a high IV rank situation or a low IV rank situation? As you heard from what we talked about before, implied volatility on Google is relatively high right now.

That means that all of these low IV rank strategies are going to be eliminated and what we’re left with are just three different choices to choose from.

We have the credit spread that we can choose from, the short call if you want to do something that’s undefined risk or something like a broken wing butterfly, so doing a put broken wing butterfly which is a bearish strategy.

Those are the things that we can choose from, and it’s very, very easy here. You can see with the strategy guide, it didn't take less than two minutes or more than two minutes here to select the right strategy and it just then comes down to your preference on risk defined or undefined risk trades, doing something that’s a butterfly versus credit spreads or short calls.

Alright, let’s look at another example here, and we’ll see if we can find a stock that has relatively low implied volatility. Alright, here's a look at Tesla, ticker symbol TSLA. Tesla has also been generally in a downtrend, but who knows.

Maybe you’re a little bit bullish on Tesla now instead of being bearish. You’re bullish, you think maybe there’s some support down here at 200, and we could see Tesla bounce off the bottom. It doesn’t matter. Just pick a direction that you think the stock might go.

Now, we know that we’re bullish and we want to check implied volatility, and we can see now that implied volatility is in the 35th percentile, so it’s relatively low. What that means is that almost 65% of the time is going back the last year, implied volatility in Tesla is going to be higher than it is right now.

If we’re smart options traders, we want to make sure that we’re trading strategies that might take advantage of a move up in implied volatility and a move up in the stock in this case because we’re bullish.

Instead of going to the bearish category, we’re going to go and move up to the bullish category and make sure that we choose a strategy that works for directionally being bullish on this trade.

Now that we’re bullish, we know we’re bullish and now it comes down to a choice between high IV rank strategies and low IV rank strategies.

We already know that implied volatility is low in Tesla, so we’re going to go ahead and cross off and not even look at the high IV rank strategies which would be credit spreads, short puts and a broken wing butterfly. Instead, what we’re going to look at is a debit call spread, a calendar spread or a back spread in Tesla.

You can see just by focusing in first on the direction of the market and then which IV rank strategy we want to go with, if we want to go with high IV rank or low IV rank, we then can narrow it down to three unique choices that will fit your particular portfolio just based on how you want to trade and the types of trades that you want to make in your portfolio.

Alright, let’s go back here and let's choose another stock that we want to look at and let’s say we want to look at Facebook. When we look at the chart here of Facebook, you can see that it’s pretty much-been range bound from about 72 to about 82 for the past couple of months.

It hasn't gone anywhere with inside that range. It’s popped a little bit and dropped a little bit, but it's been relatively range bound.

If we were directionally choosing which way Facebook might go, we might say, “You know what? We’re pretty neutral on Facebook right now. We don’t think that it’s going to rise dramatically.

We don’t think it’s going to drop dramatically. We’ve got no clear signal of where it might go in the future and maybe the technical's are also confirming that, that it might be a pretty neutral stock to trade, a stock that might trade sideways.”

Now that we know that we’re neutral on Facebook and we go down here and we see that implied volatility is in the 36th percentile… That’s relatively low just like Tesla.

It means that almost 36% of the time, implied volatility is lower than where it is right now and what that means is almost 65% of the time over the past year, implied volatility is higher than where it is right now, so this is a low implied volatility market and trade.

We go back to the strategy guide, we scroll down to neutral and you can see we've got a little bit of a different setup here. Now that we’re neutral on the stock, we have a choice of high implied volatility strategies or we actually have the choice to completely pass on the trade.

This is so important that we go over this in this video because sometimes the best trade is no trade at all and we personally believe that if implied volatility is low and you’re neutral on the stock, just pass on the trade.

You're getting no real edge in the market. You’re getting no edge in implied volatility. You get no directional edge in the market. It’s best to pass on this trade and move onto another trade or look for other trades with higher implied volatility.

This is really a key here because even though we don’t have a strategy setup for this type of market, this is exactly the type of market and trading setup where you just pass completely and move onto the next strategy.

Hopefully you guys have really enjoyed this video going through the three-step process here to selecting an option strategy. It’s very, very easy.

Don’t overcomplicate this, but make sure that you get step number one and two correctly because if you get those two correct, then you'll be very, very well setup to choose a strategy that will hopefully lead to a lot of high probability and profitable trades for your account.

As always, if you have any questions at all on strategy selection or the strategies that we went over here, feel free to add a comment in the comment box right below this lesson page. Until next time, happy trading!

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