Options Trading Checklist: How to Start Trading Options

For many participants in the options market, a disciplined, mechanical trading approach can be the cornerstone of long-term success. This mindset relies on methodical, data-driven decision-making, where probabilities guide each move, rather than emotional impulses. And by minimizing subjective judgment, traders can in turn make more informed, reliable choices, increasing the likelihood of favorable outcomes over time.

Central to this approach is a focus on key elements like market assumptions, options liquidity, implied volatility, and position sizing. Each factor serves to ensure that a trade aligns with a trader’s strategy, outlook, and risk tolerance. For those looking to stay true to this disciplined methodology, an options trading checklist can provide a valuable framework to evaluate new trade ideas. And with the assistance of a checklist, traders can stay focused, make methodical decisions, and ultimately navigate the complexities of the market with greater confidence.

Each trader’s approach will be slightly different, shaped by their strategy, outlook, and risk profile, which may lead to a unique way of evaluating trade ideas. However, for those new to the options market, some general guidelines can provide a helpful starting point. With that in mind, here are 8 steps to consider when building a systematic approach to trading options. 

1) Build a Market Assumption

A market assumption is a hypothesis about how an asset or market will behave based on available information and analysis. This can be informed by technical indicators, fundamental data, and/or macroeconomic events. Traders build assumptions to identify opportunities and direct their strategies. Whether one is expecting a rise in the U.S. dollar due to interest rate hikes, or forecasting oil price movements in response to geopolitical events, a solid market assumption is the first step in determining the direction of a trade. 

2) Liquidity

Liquidity refers to the ease with which an asset or option can be bought or sold without significantly affecting its price. In options trading, high liquidity is crucial for smooth execution. Generally speaking, options with higher trading volumes and open interest are usually easier to enter and exit, helping to ensure that trades are executed at favorable prices. Illiquid options, on the other hand, are often associated with wider spreads and higher costs, which can undermine potential profits and make it harder to enter and exit trades. 

3) Implied Volatility

Implied volatility (IV) reflects the market's expectation of how much an asset will move in the future. It’s a key factor in pricing options; higher implied volatility generally means higher premiums due to the anticipated potential for greater price movement. However, IV is not always accurate—it often overestimates future volatility. Understanding the current IV of an underlying asset helps traders gauge whether options are overpriced or underpriced, allowing for better-informed decisions on whether to buy or sell options.

4) Implied Volatility Rank

Implied Volatility Rank (aka IV Rank) measures how the current level of implied volatility compares to its historical range, usually over the last 52 weeks. A high IV Rank indicates that implied volatility is elevated compared to historical levels, which may present opportunities to sell options as premiums are higher. Conversely, a low IV Rank suggests that implied volatility is on the lower end of its historical range, which could create opportunities to buy options at a relative discount. Understanding IV Rank helps traders assess whether volatility is priced in favor of buying or selling options, or whether it is more neutral (e.g. “fairly priced”). 

5) Trading Strategy

The right strategy depends on your market assumption, the volatility environment, and your risk profile. For instance, a bearish volatility outlook in a high-IV environment might lead to a strategy that benefits from volatility contraction, like selling options. In contrast, a low-IV environment may be more suited for buying options, as premiums are relatively cheaper. Options traders often use strategies like long calls/puts, straddles, or spreads, depending on the type of move they are expecting, and their tolerance for risk.

6) Strike Price Selection

Strike price selection plays a pivotal role in determining the profitability and risk of an options trade. The strike price reflects the price at which the underlying asset can be bought or sold. Traders select strike prices based on their expectations for the underlying asset’s price movement. A trader expecting a significant price increase might choose to buy volatility. Meanwhile, for smaller expected moves, some market participants may gravitate towards selling volatility - depending on the broader volatility environment, and the IV Rank of the option in question. 

7) Expiry Date Selection

The expiry date of an option defines how much time the trader has for the market assumption to play out. Longer expiration periods offer more time for the market to move in your favor, but they usually come with higher premiums, due to the higher time value. Shorter expirations, on the other hand, may be subject to lower premiums, but may not offer the amount of time needed for the assumption to come to fruition. In that regard, the selection of the expiry date will depend heavily on the trader's outlook and strategy: for example, short-term events like earnings reports may warrant shorter expiry, while longer-term trends, like interest rate policy, may require more time.

8) Position Sizing

Position sizing refers to how much capital you allocate to each trade relative to your overall portfolio. Since options are leveraged, improper position sizing can amplify both potential profits and losses. Traders must therefore consider their risk tolerance and ensure that any single trade does not expose them to excessive risk. For instance, if an option is particularly risky, the position size should be smaller to limit potential losses. Proper position sizing is essential for risk management, and for maintaining the health of the broader portfolio. 

9) Trade Management

Trade management is a critical aspect of any options strategy, encompassing both trade entry and exit, as well as ongoing position adjustments. A systematic, mechanical approach to trade management can help ensure that decisions are grounded in logic, rather than emotion, which can help promote consistent and favorable outcomes.

Trade entry is the first step in this process, where trades are deployed based on market assumptions, liquidity, and volatility conditions. Once a trade is live, the focus shifts to managing the position effectively—whether based on profit/loss targets (managing winners/losers) or the passage of time (managing early). Managing winners/losers involves closing profitable positions early or cutting losses to prevent further damage, while managing early focuses on closing positions when the associated risks start to outweigh the rewards. 

Utilizing a rules-based trade management system is a key component of trading in a disciplined, systematic manner, helping to minimize one’s reliance on emotional, knee-jerk decision-making.

• Structured Approach: A disciplined, systematic trading approach is essential for success in options markets. It allows traders to rely on data, probabilities, and logical decisions, reducing the influence of emotions.

• Key Factors to Consider: When evaluating a new trade, factors like market assumptions, liquidity, implied volatility, IV Rank, and position sizing should be at the forefront. These elements help ensure that trades align with a trader's risk profile and strategy.

• IV Rank for Smarter Decisions: Understanding IV Rank is crucial for assessing whether options are overpriced or underpriced. High IV Rank may suggest there’s an opportunity to sell options, while low IV Rank may signal a chance to buy them at relatively attractive prices. 

• Adaptable Strategy: Your trading strategy should reflect both your market outlook and the volatility environment. Whether buying or selling options, ensuring the strategy matches market conditions will improve the chances of success.

• Consistent Trade Management: A systematic trade management approach, including well thought out entry and exit rules, can be central to maintaining discipline and consistency. In that regard, routinely managing trades based on clear criteria can help minimize emotional decision-making, and contribute to more consistent results.