The Daily Options Trading Strategy: How Relevant Factors Play A Role In Picking Trades

by: Kevin M. O'Brien

The goal of the daily options trading strategy I developed is to both get in and out of the trade as quickly as possible. On occasion, certain factors may prevent this. Market conditions, Ben Bernanke (if holding call options), or buying call options on a stock that you probably would not want to hold under any circumstance. For example, Netflix (NFLX) and (CRM) are great examples. While this may be a biased opinion, I am of the feeling that both Netflix and Salesforce are extremely overpriced. Just take a look at the P/E ratio on Salesforce and the concerning market share/finance issues Netflix has.

Before I go any further, I would like to go over in this article what this strategy is all about and how to understand it. This is mostly for those unfamiliar with this strategy, so if you already know about it, you can skip the next section.

I like to start every article with the basics on how to use this strategy with the five technical indicators. Here is a quick summary:

  • Bollinger Bands - I use the 12,2,2 as my parameters, i.e. (12) as the Simple Moving Average (SMA) and Standard Deviation, (2) as the standard deviation of the top band, and (2) as the standard deviation of the bottom band. As a personal preference, I will not begin to even consider making a trade until I see the current price action move below the bottom band (calls) or above the top band (puts), but this is only one of the indicators needed out of five (5) total.
  • Relative Strength Index - I use a length of twelve (12). The RSI is an indicator that shows when a stock is at overbought and oversold levels. It has a range of 0-100. A reading on the RSI of 70 indicates overbought levels, while 30 is considered oversold. Some traders like to go even below the standard 30 level for a buy confirmation, but it is ultimately the trader's choice.
  • Intraday Momentum Index - The IMI is invaluable as far as I'm concerned for an options trader who gets in-and-out of positions quickly. The Intraday Momentum Index is similar to reading the Relative Strength Index, in that both of them have a range of 0-100. Again, 70 indicates overbought, while 30 is considered oversold. I also use the range of twelve (12) to correlate with the RSI. Again, it is the trader's preference as to what length works and what he or she likes to use. The Intraday Momentum Index is a very powerful technical indicator to use for any type of trader.
  • Money Flow Index - The MFI follows the IMI as the next indicator. The MFI is a momentum indicator that is used to determine the conviction in a current trend by analyzing the price and volume of a given security. The MFI is used as a measure of the strength of money going in and out of a security and can be used to predict a trend reversal. The MFI is range-bound between 0 and 100 (like the RSI and IMI) and is interpreted in a similar fashion as the RSI and IMI. The fundamental difference is that the MFI also accounts for volume, whereas the RSI only incorporates price. It is also different in the fact that instead of the number 30 indicating oversold levels, the Money Flow Index uses 20 as oversold and 80 as Overbought.
  • Full Stochastic Oscillator (do not use only the Fast or Slow Stochastic) - Used by many Forex traders, I find the FSO tremendously helpful in my trades as another indicator that confirms what the previous four have already done. Combining all of these indicators together really validates when it is an opportune time to buy. The FSO is a combination of the Slow Stochastic and the Fast Stochastic and is more advanced and more flexible than the Fast and Slow Stochastic and can even be used to generate them. Readings above 80 act as an overbought signal while readings below 20 act an oversold signal. The parameters I prefer to use are (10,6,6) for daily trading.

For the most part, the criteria that a stock needs to qualify it as a trade possibility follows:

  • The stock should at least be $100/share or more (There are exceptions, which I will mention later in the article).
  • The options for the underlying stock must have liquidity.
  • The underlying stock has large price swings daily (i.e. volatile daily)

The stocks that I currently use with this strategy with are the following:

  • CF Industries (CF) - strategy works great with this stock.
  • Apple, Inc. (AAPL) - is right up there with (NYSE:CF) as a favorite.
  • Google (GOOG) - Google works extremely well, too.
  • Baidu (BIDU) - while I don't trade (NASDAQ:BIDU) as frequently, I have always had success when I do.
  • Wynn Resorts (WYNN) - another stock that works very well.
  • Netflix (NASDAQ:NFLX) - look for put option opportunities.
  • VMware (VMW)
  • F5 Networks (FFIV)
  • - look for put option opportunities.

There is a list of alternate stocks and ETF's I use, as well, that are under $100.00/share.

Among the other stocks I use are the following:

You should immediately notice that the above mentioned stocks that I added all have liquidity with their options. This is extremely important because the difference of even pennies in the bid/ask price can have a major effect in determining if the trade will be a profitable one or not.

Please see my previous articles on this strategy that I wrote on Seeking Alpha for some very useful information and comments that I have answered. They are extremely helpful. I also wrote an e-book on this strategy.

Now, back to the point of the article. Besides avoiding the obvious situations mention above, the bid/ask price of the option plays an extremely important factor when placing a trade. A few weeks ago, I was going to place a VMware call option. Once I decided on a strike price and looked at the spread, I immediately decided not to go ahead with it. The spread was about $0.45 apart. This creates a serious problem, especially when it is time to sell. At times, VMware will have poor liquidity with certain strike prices. This is especially true with deep-in-the-money strikes. For a stock that is barely over $100.00/share, the spread should be NO more than $0.25 at most. Preferably it is at $0.15 or less. For example, assume that VMware is currently trading at $105.00/share. If deciding to buy a call option using a $95.00 strike price, do not make this trade if the spread is something like $5.70 - $6.10. To get your order filled, you will need to at least use a $5.95 limit order, if not more. The real problem will come when selling. More often that not, you will need to go on the lower-end of the spread to get out.

Back to what I was mentioning earlier about not buying call or put options on stocks that you would not like to own under any circumstance. Apple is a great example. I admire people who buy put options on this stock as it is right now. When a stock is behaving out of control, as Apple has recently to the upside, please be extra cautious buying put options. If you decide to do so, make sure you are seeing an extremely overbought situation with wide Bollinger bands.

I really cannot stress enough how stock sentiment plays an important role. I am not saying to avoid a great trading opportunity, but to be extra careful. It is better to take a couple of hundred dollar loss than to hold overnight. Many people have problems doing this, but you will sleep better at night.

If you have any questions, please leave a comment or send me an e-mail. I should have some great articles out this week.

Disclosure: I am long CF, AAPL.