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When choosing an option strategy, there are a lot of things that we want to consider. Whether it’s directional assumption, liquidity or avoiding certain events, there is a checklist of things we look at before entering a trade.
First and foremost, we need to assess our directional assumption. Are we bullish (want the stock price to rise) or bearish (want the stock price to fall)? After we decide this, we can hone in on some strategies.
Events such as earnings and dividends are important to keep in mind when deploying strategies. If we don’t want to place an earnings strategy, we should ensure that the underlying’s earnings announcement doesn’t fall within our trade’s expiration. Dividend risk applies to ITM short calls, so it’s important to keep track of the ex-dividend date as well so we aren’t left with short shares that we don’t want.
While implied volatility & directional assumption play a role in strategy selection, there are also a few other factors we like to consider. Do we prefer credit or debit strategies? Credit strategies may have fluctuating buying power reduction levels, where debit strategies do not. We also want to consider trade size relative to our portfolio. We like to stay small, and keep our individual trade buying power less than 5% of our net liquidating value. Finally, we analyze our risk profile. Am I ok with selling a naked call, or would I feel better if I sold a call spread instead? These are the questions we ask ourselves when selecting a strategy.
Another aspect of the trade to keep in mind is return on capital. Am I putting myself in a position where I can realize a fair profit for the amount of risk I’m taking? Or is this trade not even going to clear commissions if it’s fully profitable? When selecting a trade, we focus on return on capital relative to risk, as well as commissions. Generally speaking, a higher return on capital results in a lower probability of profit. A lower return on capital results in a higher probability of profit. Finding the sweet spot has everything to do with your personal risk profile.
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