Ask Yourself These 7 Questions Before You Put on an Options Trade
Everyone loves a good options trading checklist, right? Here are the 7 questions you should ask yourself before you put on an options trade. Answer each one over the next week, and you'll build a strong habit that will keep your positions and portfolio in check before you put your hard-earned money at risk.
1. Does This Fit My Portfolio?
- A lot of people get hung up on adding trades because the trade looks good.
- However, it might not fit what your portfolio needs at the moment.
- Instead, make sure to add positions that relate favorably with your current positions to keep your portfolio beta weighting balanced.
- You want to add positions that are complementary to each other.
- Check out our video Balancing Your Portfolio with Beta for more details.
Example: If you have 10 bearish trades on, you do not want to add another bearish trade, no matter how good it looks. What you need instead is a bullish trade, something that will balance out your existing positions.
2. Does the Ticker Symbol or Contract You are Trading Have Enough Liquidity?
- If the trade doesn't have enough liquidity on an ongoing basis, then why trade it?
- You cannot scale a trade that doesn't have enough liquidity.
- There is no point in trading something if it only has 10 contracts of open interest.
- Instead, you want to see ongoing, high liquidity, and open interest so that you can scale up your portfolio in the future.
3. Where is Implied Volatility Rank?
- When looking at IV rank, you need an understanding of IV for the individual ticker, as well as the overall market IV.
- Any of the volatility products, such as VIX, VIXY, or UVXY, can give you a good idea of where overall market volatility is.
- It is important to know the environment that you are trading in.
- Keep overall allocations and individual ticker allocations low during low IV.
- For example, keep individual ticker allocations at 1-2% during low IV instead of 2-5% or overall portfolio allocation at 15% and have a significant cash balance.
- This will hedge against the inevitable spike in IV that will come.
4. Which Expiration Are You Trading?
- Monthly contracts do a good enough job without the frequent, recurring need to sell premium on a weekly basis.
- So, we target most of our positions on the monthly expiration.
- Again, this does not mean that you can't trade weekly expirations, they just need more frequent checking and adjusting compared to monthly contracts.
- Typically, we start building out our positions around 60 days out from expiration and stop building in that expiration period once it gets to around 25 days until expiration.
- Between that time period, we are building and laddering positions and working our portfolio out on the expiration time horizon.
5. What Strategy Should You Be Using?
- By default, you should be using mostly options selling strategies.
- This does not mean that you can't use an option buying strategy, but it is more of a hedging technique.
- When you look at your options trading holistically, you want to be a net seller of options premium.
- This means you should be doing straddles, strangles, iron butterflies, iron condors, credit spreads, etc.
- You just have to decide which side of the market you ultimately want to be on. Is your portfolio generally neutral or is your portfolio skewed bullish or bearish?
6. Have You Double Checked Your Position Size?
- When you get through the list of checks, double-check your position size right before you enter the trade.
- This is one of the last things to do, and you should know intuitively where you position size should be.
- Look at the order screen to see what your maximum risk is, or what the margin is that is required to carry the position.
- Position sizing is ultimately one of the things that will lead to most people failing in options trading.
7. What If?
- This is the most important question to ask after you've placed the trade.
- Once the trade is placed, start going through all the "what if" scenarios.
- Explore how you would adjust or hedge the position if the worst-case scenario happened.
- Prepare for each scenario by doing research and choosing strategies to prevent major losses. Check out our series, Trade Adjustments/Hedges, for a detailed look at adjusting or our podcast, OAP 087: The 3 Option Adjustment Principles You Must Know Now.
- This preparation will help you when the time comes to make an adjustment and allow you to react faster.