Our 10-Step Options Trading Checklist Used Before Placing Trades

You’ve lost money …

… I’ve lost money…

However, the trick is … to make more than you lose … right?

It requires you have a system that works.

Of course, there is a lot noise out there … coupled with uncertainty, all of which, causes investors to not to trust their instincts and gut feelings.

In order for you to sift through the noise … first, you need a process that ensures you’ll have a positive expectancy over the long haul.

Don’t get me wrong … short-term pitfalls will arise. However, to stay the course, you need to stick to your system once it’s a proven winner.

The process I provide, below, is my approach to trading equity options. It’s been battle tested for nearly a decade now. Before perfecting it, I went through my fair share of bumps and bruises, given to me by the market.

Now … don’t be afraid, you’re not going to be overwhelmed by any bells and whistles … just a sound system that’s wickedly effective. One that could potentially guide you to consistent profitability in the options market.

1) Idea Generation

Make no mistake about it … investing is a numbers game.

With that said, I don’t place trades for the sake of trading … nor do I put on trades expecting to lose money.

However, I do look for certain setups within the options market … if I find one that I like … I’ll pounce on it. In the past, when I didn’t have a great plan or focus … I’d get overly emotional on my trades. In fact, I’d take losing very personally. As I’ve gained more experience, I know that some trades will be losers, regardless of how great they may appear at first glance. I’m fine with that, as long as I’m focused on the opportunities that have a good probability of success.

I keep my ideas simple. I’m either looking for opportunities to sell options in which I believe premiums are inflated … and offer a good opportunity for success. I compliment that approach by generating ideas based off unusual options activity … something I call the SIZZLE Method.

The bottom line is … you need to know where your idea is coming from because it provides a basis on what expectations are.

2) Where Is The IV Percentile?

The higher the volatility is in an option … the more expensive they are. Since I primarily enjoy selling option premium … I try to find options that are “relatively” rich compared to previous implied levels. I’m able to quickly tell if options are either cheap or expensive by observing the IV Percentile.

The IV Percentile tells me if option premiums are at the high end of the range, middle or low end of the range. To get this information, I’m using my broker’s platform, thinkorswim by TD Ameritrade.

3) What Is The Price Of The Stock?

By knowing the price of the stock, I’m able to get a better idea of how to structure my trade and how to size it. For example, if I’m trading a high priced stock, I might avoid selling options naked because that could eat up a lot of margin.  

4) Is There Liquidity In The Options?

Ideally, you’d like to trade options on stocks that have a healthy amount of volume and open interest. Stock options generally have healthy volume, open interest and competitive bid/ask spreads.

You want avoid stock options that are illiquid … if you don’t … you’ll incur a lot of losses, in the form of slippage.

5) What’s My Expectation?

Before placing an option trade, you should have a firm understanding of the risk, profit potential and the expected duration of the trade.

Now, if I’m selling option premium, I’m expecting the implied volatility to come in … or revert back to the mean. Of course, time is on my side, and the closer the position get’s to expiration, the more that time premium gets sucked out of those options.

If I’m buying options, I’m primarily taking a directional view on a stock.

By being aware of what can happen … allows me to intelligently manage my positions.

If I’m I’m collecting a credit, I’ll look to buy back the options I sold for a 25-50% discount from where I sold them.

If I’m buying options on a directional play … I’m looking to close the trade, 25-50% higher from where I paid.

6) What Should My Time Frame Be?

Depending on the the trade idea and expectations … time frames on trades will vary.

For example, if I’m trading earnings, I’m generally playing for that 1 day … win lose or draw, I’ll be out of the trade.

Now, if I am trading weekly options on the SPX or SPY … I may hold that trade for two to three days. This is an approach I teach in my SPX Method course.

In addition, I’ve learned from the research team at tastytrade.com, that a 40-50 day window provides the most optimal period for selling option premium. That’s when the time decay really starts to accelerate.

7)  What Strategy Shall I Use?

After I’ve reviewed the IV Percentile, the price of the stock and the options liquidity … I’ve got a pretty good idea of how I am going to structure the trade.

Remember, an option strategy is just a representation of your trade idea. Too many times you’ll hear or see about specific option strategies being promoted to the public. Of course, this is just a marketing ploy.

There are only two types of option strategies, defined and undefined risk. Everyone has different risk tolerance levels … and no one strategy is better than another.

8) What Is The Probability Of Success?

Within my trading platform, thinkorswim, there are a couple of useful features I use to gauge the probability of success on my trades. One of those features is called the probability in-the-money. Basically, this gives me the probability on whether or not an option will expire in-the-money.

The second feature I use is Probability of Touch. This gives me the probability at which the underlying stock price may test the strike, during it’s life cycle. This is important if you’re selling options via structured trades. Again, this prepares you on what to possibly expect during the lifespan of the trade.

9) What Is My Max Risk?

Position sizing is a problem investors from all levels experience, one time or another. By structuring trades accordingly, I’m able to avoid big losses to my trading account. With that said, it’s important to identify the max risk from each trade.

10) What’s My Position Size?

One of the best ways to manage risk is by sizing your position accordingly. Also, take into account the probability of success. For example, in my cases, buying options offer a low probability of success. However, if you do choose to trade like that, size the trade accordingly … with the expectation of losing a large portion or all of premium spent.

On the other end, if you’re selling option premium, you don’t want to be over-levered, forcing you to make several adjustments or get hit with a margin call.

Generally, for premium selling strategies, which have a probability of success when filtered out, I’m willing to risk anywhere between 1 to 5% of my portfolio on a trade. On the other hand, if you’re interested in premium buying, stick to risking around 0.5% to 3% of your portfolio.

These are not hard rules, but could be used as a specific guideline to follow.

Bonus Tip: I want to make sure that my positions aren’t overly correlated. Are your positions bullish, bearish or neutral? Are they in the same sector or move with the general market?

Even if you’re only risking a small percentage of your portfolio per trade, if several positions are highly correlated, and it doesn’t work out, those small losses could add up.

Now, if you’re ready to roll up your sleeves and get your hands dirty … it’s time to check out Fearless Investing With Options. It covers this entire approach in full detail, packed with actual trade examples that make it easy to follow along. But before we get into the nitty gritty … there is a complete overview of the essential fundamentals that will help you get to the next level.