Building the Ideal Options Trade in Volatile Markets

Unlike straight-up, buy-and-hold stock investing where you purchase a stock and wait for it to go up, options allow you to take the "hoping" out of that process. You don't have to care whether a stock is going up or down, just as long as it moves in the direction you think it will -- and quickly, at that!

No doubt you're being bombarded with financial news headlines and wondering how to make sense of it all. But while the broader markets are popping or plummeting, individual stocks and sectors are oftentimes operating in their own universe -- it's not unusual to see technology names running up while the financials are going down, and vice versa.

And while stock investors are seeing turmoil and running for the sidelines, as options traders, we're able to buy calls in the winning names and buy puts in the losing names. Not only are we able to trade while everyone else is heading for the hills, but we're also able to profit handsomely not only in spite of the current market conditions, but even because of them!

The Cornerstone of an Ideal Trade: The Right Price

When it comes to the ideal trading opportunity, the most important ingredient in my book is getting a good price. And that means finding undervalued options or ones that haven't yet reached their potential worth.

Not only am I seeking options are worth far more than their asking price, but I also don't want to pay more than $2 ($200 per contract) for them. Why? Because they have the best potential risk/reward scenario.

I'd rather pay $1 for an option that can double in value in the next few weeks than pay $20 for one that might only go up a few cents. That's a lot of capital to tie up for a small payoff -- and it's a whole lot to lose if the stock doesn't trade in the direction we think it will.

There are many traders who don't blink at paying $50 or $100 per share ($500 or $1,000 per contract), but it's difficult-to-near-impossible to double your money when it costs so much to enter a trade. When your brother-in-law or colleague tells you that he "lost his shirt" by trading options, he probably put all his money into one trade like this.

Don't let someone else's bad experience -- based on inexperience -- deter you from getting into the game. There are plenty of amazing opportunities for incredible returns... if you know where to look for them!

Other Things I'm Looking For

What's the Trend?

After you've been trading for as long as I have, you come to recognize trends in stocks. You get to see how they behave at certain times of the year, and you learn whether or not they stay strong when the broader market enters a period of weakness.

I'm a statistics guy at heart. I've perfected my own proprietary system throughout the years to run an exhaustive battery of data analysis on stocks every week to see where they're heading in the coming weeks.

Is There Momentum?

Next, I select the stocks with the most momentum and pore over their option chains. Whether the stocks are moving to the upside or downside doesn't matter to me as long as they're on the move.

If the options look overvalued (that is, they don't have much room in them to make a move), I immediately disqualify them from my short list of potential trades. Unless there's that magical combination of a low price and big potential movement, I'm not interested in them!

Could There be a Breakout?

You may be wondering what stocks I'm looking at, at any given time. All of them, really, but I give special emphasis to those that are breaking out of tight trading ranges. If a stock has seemingly been stuck for a while but is starting to climb to new levels, it's worth a second or even a third glance from me.

What's the History?

Something else that I look for is how the stock trades around earnings and other events like new product releases and industry conferences. Seasonality is a historical indicator that gives you a pretty good idea of how a stock is going to trade in the next quarter or two. And if a retail stock tends to go up before the holiday shopping season, for example, it usually holds true that its options will be making a move right along with it.

Historical information is only part of the story for a stock, particularly when it comes to volatility. Seasonality shows us when shares typically pick up in volume and momentum throughout the calendar year, but volatility can crop up quite unexpectedly, too.

Can I Anticipate a Surprise?

Surprise volatility can happen when a stock receives an analyst upgrade/downgrade or when a major hedge fund or institutional trading group decides to pile into/out of a stock, which oftentimes leads many individual traders to follow suit. The trick is to be positioned before such a move takes place, and the payoff can be incredible when it happens!

The bottom line is that stocks in motion equal options in motion. But it's up to you to spot the signs.

Ken Trester started trading options when the first exchanges opened in 1973. He has been a computer science professor at Golden West College in Huntington Beach, CA, where he also taught a course on stock options trading. Ken is also widely quoted in publications such as Technical Analysis of Stocks & Commodities and Barron's.

Ken is the editor of Fast Options Profits and Maximum Options, both of which provide options trading recommendations for beginning to intermediate traders.