I’m a total amateur at selecting options, so my methods are probably worthless, but here is what I do…
First, I don’t even think about options unless there is out-of-normal (variation) market fluctuation that I am VERY CERTAIN is coming, AND others haven’t priced that in yet. For example, the S&P500 is peaking at 1500, yet the housing market is collapsing, so I expect the stock market will fall dramatically.
Then…
1) I write down my hypothesis, such as, “The S&P500 will fall at least 10% in the next twelve months”
2) I look up the prices of options with expiration dates far beyond the time frame within which I think the market event will occur. (In anticipating market events, we are often biased to expect they will happen MUCH SOONER than they actually happen – we are biased by our wishful thinking! Just ask Rich and I when we originally guessed the home builder stocks would collapse!)
3) I pull down all the current pricing of a type of option, across a wide band of strike prices, and dump them into my Excel spreadsheet. Often there may be 100 rows of various options (for example, all PUTS on the S&P500 that expire 12 to 36 months out.)
4) Using steps in my hypothesis (Market drops 10%, 15% and 20%), the columns in the spreadsheet calculate: A) % return on investment; B) % market drop required to reach break-even on purchase of a particular option; C) actual net profit on one contract
Using that data, my spreadsheet plots curves of % ROI as a function of strike price, plotting separate curves for each step of my hypotheses (For example, -10%, -15%, -20% market move of S&P500)
I also plot break even point (expressed as the min % of market move required to reach break even on a particular option) against strike price.
The curves are most important: I chose options by looking over those curves. Understand, each chart with curves is for options with the same exp date, but I may create several similar charts to compare curves for different expiration dates.
I usually end up buying the options that break even after a very small fraction (as little as 3% to 5%) of my anticipated market move…and also are close to the MAXIMA of my lower %ROI curve, plotted for the conservative value of the correction (in this case 10%) that I expect.
Of course, this kind of analysis will typically steer you away from those dirt cheap out-of-the-money options…to options that inevitably have much higher nominal prices because they are in or near to in the money. I’ll typically buy options that might be $5, $10, or more each. So you’re talking maybe $5,000 for 10 contracts. So this is a safer way but requires larger amounts of money, compared to gambling say $500 on $0.50 out-of-the money options.
You see the reason I don’t chose the $0.50 options that maybe maximize the ROI for a much larger market perturbation (such as a 20% fall in the S&P500) is that the break even point on those options will require a market perturbation that is much less likely (such as a 10% or even 20% move in the underlying security)
People think options are risky, and yes they are. But consider that I bought PUTS on the S&P500 back in Oct ’07 when the S&P500 was over 1500….and yet those options had a break even that only required a ~3% drop in the S&P500!
Were those particular options THAT risky, given market and the unfolding economic conditions? I don’t think so. That’s why I spent 7% of my entire portfolio buying them.
