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Option Basics - Criteria for Trade Entry

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While many traders consider trade management after a position is placed (especially for losing positions), considering the risks before a position is placed (before initiating a trade) is far more important.

Let's set some guidelines when considering the viability of an option trade prior to placement.

First, option liquidity. Liquidity simply means that there is enough volume and open interest for the option (at a specific strike) that you avoid unnecessary slippage (wide bid and ask spreads).

The guideline here would be as follows: the daily trade activity for the underlying should be over 1 million shares; the daily volume for the option should be at least 100 contracts; and the open interest for the option should also be at least 250 contracts.

Generally, the greater the liquidity, the tighter the bid/ask spread.

Second, minimize risk to your account by keeping size small. Trading large size is the biggest reason traders go bust (bankrupt their account).

The typical guideline is as follows: when trading multiple underlyings, keep each trade under 3% of your account size. Your portfolio size should be limited to 50% or less of your account size.

Note: if you are trading one underlying and one position at a time, and it's an index (like the SPX) that offers diversification, then the criteria is just portfolio size (less than 50% of account size) for each position.

Third, high IV rank. When IV rank exceeds 50% for an underlying, the probability of profit (POP) increases for credit (or premium) strategies. This is because increasing implied volatility means more option premium and further OTM (out of the money) short strikes.

IV rank is a major metric when selecting multiple underlyings to trade.

Fourth, best time of day to trade. In general, whenever there is high volume it is easier to get a fill. This normally occurs at the Open and Close of the day. However, if you have a directional bias, then entering a bullish position (like a bull Put) is best when the underlying is falling and you think it is near a bottom; entering a bearish position (like a bear Call) is best when the market is rising and you think it is near a top.

In most of my trades, I prefer the Close of the day.

And fifth, ideal DTE (days to expiration). If you like trading monthly options where you expect to exit the position prior to expiration, then the preferred DTE is around 45-55 days. However, if you prefer trading the weekly options, then the recommended DTE is 7 days (enter the trade at the Close on Friday with 7 days remaining in the option). This gives you an opportunity to exit the trade early (having reached your profit objective), or to hold through expiration (a viable approach for European style options).

In conclusion, following the guidelines above should improve your trade experience.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.



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