Basic Checklist for Buying a Call: Part 1

Open a virtual trading account to practice what you pick up in each module

Basic checklist for buying a call:

Locate a potential candidate: Finding potential stocks to trade can actually be quite easy; you can consult websites, TV, friends, workmates, family, etc – you can even look around your home for ideas. The hard part may be finding success in the stocks you uncover. Stocks are on the minds and lips of most Americans; getting stock ideas and making trades solely by word of mouth is an extremely general and often risky proposition, if you don’t do your homework. There are many tools available which enable you to search for a certain stock based on its price, sector, fundamentals, analyst recommendations, chart patterns, options strategies, etc.

Be sure that once you have located a stock you perform your due diligence. This process may include, reading the analysts reports, checking the news, checking past earnings dates and results, and noting upcoming earnings. Surfing the web is actually a great place to start, just make sure the sources you use are reputable.

When forming your trading plan, be sure to specify how you will go about locating potential trades. Many traders tend to focus on a group of stocks, this is acceptable – just be sure that you don’t pigeonhole yourself into just one group that may not be performing well.

I’ll be using actual companies as illustrative examples during today’s presentation instead of the infamous “XYZ Company”. None of the discussions should be construed as recommendations to buy, sell or trade a specific stock or use a certain strategy. The opinions I express throughout this presentation are my own…you will need to form your own educated opinions. Remember, only you can determine if the option strategies discussed are suitable for your investment portfolio.

Practical Application: I typically trade the same group of 15 stocks over and over. As a market maker, I became accustomed to trading the same issue all the time; therefore, I got extremely familiar with its earnings reports, trading patterns, volatility, etc. One of the stocks I have traded over the years is Google (GOOG), which has seen its stock price cut by 60% in less than six-months’ time as of today. (It took 2.5 years to get from its current price level to its all time high. Fundamentally, I like the stock – I mean, aside from the financials, statistically Google is the world’s largest search engine, on the cutting edge when it comes to technology and innovation, and they are always exploring new ways to make money. So now let’s begin to examine the rest of the parameters.

Fundamental Analysis: Some traders look for certain characteristics in the companies in which they invest. Fundamental analysis, (which means analyzing a company’s financial statements, management, and competitors), becomes much more important with regards to longer-term investing, as you obviously want to invest in a company that will not only be around in a couple years, but will thrive. For day traders, fundamental analysis becomes less of an issue; in fact, there are some active traders who may trade a stock they know nothing about. Personally, I feel having knowledge and some level of familiarity with a company and its sector can only benefit you and increase your confidence in your trading decisions.

Practical Application: GOOG has a market cap of $92.5 billion and are one of the top performers in their sector. The company’s after-tax profit margins are good compared to the rest of the sector, checking in at roughly 20% (as of the end of 2008) GOOG has been running at roughly a 25% profit margin over the past four years, on the average. This is only one indicator to consider, there are many other factors that can be used to evaluate a company’s financial health and standing within its sector. Certainly GOOG is feeling some pain with the world in an economic downturn. I have noticed its ability to adapt in a changing marketplace. You may choose to go deeper into fundamentals, but I know that I am more of a shorter-term statistical trader and am satisfied with the small amount of research that I have done thus far. Please remember that my trading patterns and habits may not define your habits or pattern Also remember that I have traded GOOG many times in the past and feel comfortable with the behavior of the stock and its volatility. One last thing I like to glance at, not that this is going to insure success in a trade, is analyst recommendations. Out of the 21 major analysts that follow the stock 16 rate it a “strong buy,” 3 a “buy,” and 2 a “hold.” The mean 52-week price target for the stock is $475.00. Realize that analysts can NOT predict a stocks direction, nor is it feasible for anyone to pick the exact price a stock is going to be at in a given period of time. All they can do is give a best guess at the stock’s direction based on certain factors that they deem important. Even though I understand this risk, mentally, knowing that analysts are bullish makes me feel better about my trade.

Strategy Selection: Since we are discussing the long call, this is obviously the strategy we are going to discuss. Options provide a vast arsenal of strategies that traders can employ in the marketplace. As you broaden your strategic knowledge, you will be able to find the most appropriate strategy for the situation the marketpresents you. The market is forever changing, and no two days are exactly the same; therefore, having a strategy to fit just about every situation will leave you better prepared to face the markets.

Practical Application: In this example, we are looking at a simple long call. I am typically an active-to-swing type trader, meaning I usually stay in my positions anywhere from a couple of minutes to about three days, max. This is important to determine BEFORE you place your trade. It not only helps determine what strategy you employ, but also how much time you buy. GOOG hit $340.00 on 1/6/09 and has since been hammered down to $295.00 as of January, 20th 2009. The market has really been struggling here; horrible employment numbers, foreclosures, and Bank of America is asking for more TARP funds to help buffer the acquisition of Merrill Lynch. The situation seems very bleak, but as a professional (and experiencing these types of situations before), I am deciding to take a calculated risk.

Technical Analysis: Many investors use some form of technical analysis, and there are a multitude of charting packages, indicators, etc. Obviously some indicators are better than others, and many would agree that (for the most part) technicals work better as you target shorter-term trends and reversals. Basically, find an indicator that is easy for you to understand, one that offers you some edge and a potential advantage in your entries and exits, not to mention gives you some guidelines when monitoring your trades. Some of the indicators that traders use are MACD, Stochastics, Elliot wave, and Moving Averages. The more indicators that you follow the more difficult it may be to execute your trades efficiently and effectively. There are no guarantees of success with any analytical tool, and the more you add the more muddled your results may be. What I can say is you must try to use as much consistency in your analysis and quality in your execution and money management.

Practical Application: I use technicals to confirm my bullish thinking and trigger my entry, the key to any market trading system is simplicity. You should have your stock, strategy, and money management plan in place before making any trade! The reason for the plan is to try and mitigate any surprises. However, even with the best planning, you can still be wrong in a trade at follow-up. Planning is also important in the mental preparation for your trade and to establish realistic expectations.

ALL TRADING SYSTEMS ARE FLAWED, none will offer you perfect results. In fact, some don’t offer any results at all. Look for a system or method that can offer you an edge, just a slight advantage when it comes to timing your entries and exits into and out of positions. The more complicated and longer trades take to analyze, the more difficult it will be for you to execute and be successful. I use a proprietary system that is easy for me to read and understand. I also take a look at standard 20, two standard deviation Bollinger bands and look for oversold or overbought conditions. (This is an advanced technique that will require study, it is not intended for every trader) Frankly, I believe the only reason that any technical analysis works (besides measuring deviation from an average price or mean) is that enough people follow and execute the parameters so perception becomes reality. Again, this is just my personal view. Be sure to paper trade and test your methods and systems before applying real money to the trade.

Delta: Before clicking the buy button, be sure that the call you are selecting meets your trade-style objectives. Each and every trader will have a different pattern, different financial needs, and different goals and time frames to their trading. First and foremost, most traders have a hard enough time picking a stock that is going to move in the direction that they desire. In fact, it may be harder still to find an option with the best balance of leverage, probability of success, and enough time to expiry. Luckily there are some simple guidelines beginning traders can use to find the best potential call candidates.

If you want to trade an option that behaves the closest to the stock, look for a delta 0.70 to 0.90. This is MY method and does not mean that every option with a 0.70 to 0.90 delta will behave exactly like the stock, nor does it mean that you will be successful trading this type of an option, it is purely a guideline. . Trading a call with a high delta may solidify the relationship between stock and option (generally speaking, an option with a higher delta has a tendency to behave more like the stock), it will also help ensure a high intrinsic-to-time ratio and will increase the chance that the option will move when the stock moves. Buying a lower delta is not necessarily a bad thing; just understand that the relationship between stock and option will be more dependent on other factors, meaning the stock may have to move further, faster for you to potentially profit. When placing a directional trade, in other words, if you are just buying a call because you feel the stock will increase in value, the delta that may NOT be desirable to purchase would be the 0.40 – 0.60 range, as the at-the-money options have the most amount of time value, relative to the other options. Remember, time value is the decaying part of the option (more time value means you must lose more per day to get to zero by expiration). Having the most amount of time value means the option is also the most sensitive to volatility changes.

Practical Application: For my GOOG example, I am staying in the money. I am executing this strategy for several reasons. As a rule, I like to buy a 0.70-0.90 delta. Here is my logic (usually it falls into line): First, let’s take a look at the average true range (ATR) of GOOG.- the average deviation of GOOG over a recent month’s time is 45.00. The ATR is a rolling 14-period average of a stock’s greatest movement in that given time frame and can be used to measure minutes, days, weeks, months, etc. I use ATR as a gauge to place my stop losses, I usually multiply the ATR times 1.2 to find a stop loss for my intended period I do this to stay outside of the stock’s ‘normal’ variations, this is a personal preference. To simplify the math : 45 (ATR) x 1.2(my risk factor)= $54. This means that $54 would be my acceptable stop loss in the stock. This means that if the stock is trading at $300.00, I would subtract 54.00 from the current trading price to find where to place my stop order. In this case, $300 – $54 = $246.00. A friend of mine also showed me a neat little trick, you can subtract your stop-loss amount from the stock price and that’s the strike that you buy (Again this is just a formula that he uses and does not guarantee success in the trade. Using this formula, if GOOG is $300.00 and I subtract $54.00 from it, I may purchase the 250 or 260 call, as long as it falls within the 0.70-0.90 delta range. The call I chose was the March 260 Call for $51.00. If your wondering why I chose March expiration, that is the next part in my checklist.

I have found that if you are using the monthly ATR as your stop-loss gauge, it tends to put you in range of using the above method to find your delta. So the question is, now that I have chosen my option, do I set a stop loss or do I have to lose everything? Here is my method, I take the ATR of the time frame that I want to be in the trade (MONTHLY MAX) then I multiply it by 1.2 then multiply by the delta.

So if my ATR is 45 and my option has a 0.70 delta the math looks like this:

Entry Price [51.00] – ((45[ATR]*1.2)*0.70 DELTA) = stop loss of $37.80.

My stop-loss order would be placed at my (entry price [$51.00] – loss amount) or $16.20 in this case This loss may seem steep, but remember that you were willing to originally tolerate a $54.00 loss in the stock, all the while having $300.00 per share tied up in the trade

Expiration: Having enough time for your trade to work is a risk many options traders have to contend with. One of the ways to determine how much time to buy is to look back on your past trading history. If you have a history of being in trades for an average of a month, then maybe you should buy a minimum of 60 days to expiration (DTE). If you have never traded live before, you should practice trading your methods. Take a look at your practice trades in your virtual account and use those as a guide to how long you tend to be in trades. Before you begin to trade real money, be sure you understand all risks involved, as a general rule, you should place at least 25 or more trades in your virtual account and have a written trade plan before using real money.

Here is an easy formula: Look back at your past two years of trading (or your total history if less than two years), then take all the trades you made and take the time you were in them and average them all. Then take your longest trade and average those two numbers (the average and the longest trade) – whatever number you come up with, add 30. The result is a good minimum DTE to purchase when you are making trades. This is a formula that I have developed myself, it does not guarantee that you will always buy the right option, but it is a guideline to start with. I use this guideline because many traders that I have taught over the years have experienced a trade where they felt they needed to hold an option longer than expected. This situation is why I choose to add 30 (or more) days to my average trade length.

Obviously, purchasing more time for what you deem to be a more long-term investment is generally not a bad thing, although I would be careful buying less time, as we all know that sometimes things don’t go exactly as planned in the market,. Having more time in your trade may open some other “options” that you may not have had available to you if you were out of time. Most traders do not want to be long an option with 30 DTE or less, as time value begins to erode more exponentially the closer you get to expiry, Experienced traders who understand the more advanced behaviors of options may chose to trade front month options.