10 Keys To Stock Option Trading!

Your analysis has to start with the market. 75% of all stocks follow the market. To put that another way, 3 out of every 4 trades will lose money if you are on the wrong side of the market. This is one of the biggest mistakes made by novice traders.

Every week I refresh my long-term bearings. I start with a 5-year chart and I continue to zoom in using a variety of charts. This practice helps me visualize how the current conditions fit into the big picture. In the chart below I have identified long-term support/resistance levels and I have noted changes in my longer-term bias.




It is also important to look at a 3-month chart for short-term trend lines, moving averages and horizontal support and resistance levels. A short-term perspective will help you pick good entry/exit points. You need to be aware of seasonal patterns. The Stock Trader's Almanac is an excellent resource. You also need to be aware of earnings and economic releases since they can have a big impact on the market. Option expiration and end-of-month fund buying are two additional influences you should be aware of.

Even the best stock option trade is likely to fail if you are on the wrong side of the market.

Develop a systematic approach to finding the right stocks. Quantitative models like CANSLIM, technical analysis screeners that look for moving average crossovers and stock option research reports are a few examples. You need to zero-in on stocks that meet your criteria.
The screen shot above is my OneOption Scanner. It narrows 20,000 stocks down to 300 stocks everyday. I flip through the charts and I use my pattern recognition skills to spot opportunities. I have some very powerful free scans. Try them out.

Some of the most fundamentally sound companies trade at reasonable valuations. Unfortunately, they can sit idle for months or years. Options are a wasting asset and you need to trade stocks that are on the move. This even holds true for option selling strategies. Don't sell options on a flat stock. The volatility is low and you won't collect much premium. You also won't have the momentum of the stock to provide a "cushion".
Start with technical analysis. I look for trends, gaps, breakouts and range days. I start with the recent price movement and then I zoom out for a longer-term perspective. In particular, I am looking for strength/weakness relative to the market. When I get the market wrong, it's common for me to avoid a loss and sometimes I even make money on the trade. When I am on the right side of the market, the profits in these stock options soar.

When a stock is on the move, you have to know if the driving forces are "fluff" or substance. Brokerage upgrades/downgrades, short squeezes and take over speculation are "fluff". Earnings, major contracts and FDA approvals are substance. After I review recent news releases, I go back to the last earnings release. I review the financials and I read the guidance to get a clear picture of the macro conditions.
Fundamental analysis will give you staying power. Knowing why the stock is strong or weak will help you stay with the position if the stock option starts to move against you. The screen shot above is taken from my Level 1 Option Report.

Your opinion is provides the framework for the option trade. You need to determine how far the stock will move and how long it will take. If you feel the stock will explode higher in the next week, buy a front month out-of-the-money call. If you feel the stock will steadily grind $4 higher for 2 months, buy an in-the-money 3-month call. This strategy keeps you from buying a lot of implied volatility. The options will move point-for-point with the stock and you will be able to take profits along the way. Since the options are trading near parity, the position is barely exposed to time premium decay.
In the example above I continue to add supporting information as I build my opinion. Your opinion of the direction, duration and magnitude of the move will direct you into the right stock option trade. The strategy, the month and the strike price should reflect your opinion.

Compare the current implied volatility of the stock options to their historical implied volatility. If the options are at the low end of their 1-year range, lean towards buying put or call options. If the options are in the middle of their range, consider option spreads. If they are at the high end of their range consider stock option selling strategies. Avoid selling stock options where the implied volatility has spiked. That indicates that news of some sort is pending and the stock is surrounded by uncertainty.
In the chart above you can see that the blue line represents the implied volatility (IV) of the options. In this case the IV is in the middle of its 1-year range. By most standards an IV of 40 is high, but it is normal for this stock. I believe the stock will make a $9 run and challenge its old highs in the next 2 months. I opted for a long term deep in-the-money call purchase to avoid paying a lot of IV. This trade is essentially a leveraged stock position.

Let your confidence in: the market, your analysis, and your recent trading determine the position size. Like a professional black jack player who counts cards, you have to increase your size when the probabilities of success are high. Conversely, when you can't get a good read on the market, trim your size.
The stock above has formed a base and it has broken minor resistance and the 100-Day MA on the rebound. Basic materials stocks were making new all-time highs along with energy. The market was within striking distance of a new all-time high. My conclusion was that the market was strong, my analysis was sound and I knew that I had been trading well. The probablity of success was high and I was aggressive with this trade.

Form a game plan. Know exactly where and when you will get in and out of the stock options. These key levels will force you to admit when you are wrong. They will also keep you from getting greedy when you have a winner. The game plan will help you control your emotions and it will keep you on the straight and narrow.
This was the game plan for the trade above. If the stock continued to show relative strength, I would stay with the position until it reached $54. If the market faltered along the way, I would look for opportunities to sell near term out-of-the-money options against the long to hedge risk and generate income. If the stock broke below the 100-Day MA, I would exit half of the position. If the stock broke below the short-term trend line, I would exit the entire position and wait for another opportunity.

Never allocate more than 10% of your capital to one trade. You will have losing option trades and bad news or a market event can strike at anytime. Spread your capital out across at least 4 diferent sectors. If you are heavily concenrated you will be taking on unceccessary risk. Don't let one bad decision wipe you out.


When I am market neutral, I carry a mix of longs and shorts. I trade relative strength and weakness and I always keep a deep watch list of bullish and bearish stocks. Within my Daily Option Trading Report I have a dynamic table that monitors all of the stocks in my bullish and bearish watchlists. As you can see in the screen shot above, the best candidates rise to the top of the table and at a moment's notice I know right where to look. If I have a market bias, I weight my portfolio in that direction.

Successful traders do what unsuccessful traders won't. The key word is won't. All of the little things add up and they make a big difference. In that spirit, here is a very important resource that most traders are too lazy to take advantage of.
Keep a trading log and record each of your stock option trades. Take time to right down your thoughts (good and bad) so that you can identify areas that need improvement. This task is a pain, but it will make you a better trader. It might be weeks before you can go back and review your thoughts. You will never remember the details once time has passed. Once you start reviewing trade after trade, you will be amazed at the information you can pick up. I've been doing this for 20 years and I will forever be a student of the market.

Want more free trading advice? I offer daily market commentary and free education at my stock option trading blog.

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Stock - Zumiez, Inc., a mall-based specialty retailer, provides action sports-related apparel, footwear, equipment, and accessories. This company sell skateboards, snowboards and all the accessories that appeal to the X-treme crowd.




Rationale - In August the company said its second-quarter profit climbed 90 percent on a big boost in sales at stores open longer than a year.

For the quarter ended Aug. 4, net income rose to $3.1 million, or 11 cents per share, from $1.6 million, or 6 cents per share, in the prior year quarter. Revenue rose 47 percent to $82 million from $55.8 million in the second quarter of 2006. Analysts predicted revenue of $80 million. Same-store sales, or sales at stores open at least a year, jumped 11.6 percent in the quarter.

It boosted its 2007 earnings guidance due to strong results during the first half of the year. Zumiez said it expects earnings per share between 97 cents and 99 cents for the year, up from a previous estimate of 94 cents per share to 96 cents per share. The stock trades at a forward P/E of 37.

The company announced that net sales increased 39.7% to $47.0 million and August 2007 comparable store sales increased 17.4%

Strategy - I have been in the stores and they have extreme brand loyalty. The stores are always busy and they are the place to go for many teens that are "malling". If you look at retail sales across the board, they have been weak and mall traffic is down. However, this company has shown fantastic same store sales increases. Teens will spend whatever it takes to "look cool" and I do not believe they are as sensitive to economic conditions as other consumer groups.

As the market makes new highs and the ecomomy shows moderate growth, retail stocks will rally from depressed levels during holiday season. This stock will lead the charge and it has been strong relative to other retail stocks.

Trade - Sell the ZUMZ November 45 puts and buy the ZUMZ November 40 puts for a net credit of $1.15. This is called a credit spread. The trade will be profitable if the stock stays above $45. I expect it to move higher. The downside risk is $3.85 (the difference between the strike prices less the credit received. We are not going to let the loss get to that point.

Stop - Contingent on the stock below $44, buy in the spread. Notice how the stop is below a support level. This stock will have to breakdown in order for the trade to be in danger.

Target - We want the options to expire worthless so that we can keep the $1.15 credit.

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