How To Find New Potential Trades – Step By Step Guide

Finding new trades and setups can be one of the hardest and most time-consuming things in many trading styles. This is luckily quite easy for high probability options selling. If finding trades is easy, trading won’t take a lot of time and that is also why you easily can trade like this with limited time and a full-time job. In this article, I will discuss what exactly you will have to look out for when searching for new setups/underlying assets to trade on.

Step 1: What Do You Need The Trade For?

First of all, it is important to know what kind of trade you are looking for. There are multiple aspects to consider when choosing this. Probably the most important one being your current portfolio. If you have a bigger account, you will most likely have multiple positions open at a time. When you have multiple positions open at once, you should try to have a relatively neutral and uncorrelated portfolio. I discuss this in much more detail (in this article) in my advanced course. An overall neutral and uncorrelated portfolio is very important for bigger accounts. Therefore, when opening new positions you should consider your current portfolio. If you have more or only bullish positions, then look for a bearish position and vice versa. Always try to add positions that make your entire portfolio more neutral. After looking at your portfolio, you should roughly know what trade to look out for. If you have a smaller account with only very few positions open at once, the aspect of a neutral portfolio isn’t that important. Nevertheless, I still recommend choosing a strategy before searching for specific underlying assets to trade. I always do this and the reason for that is because different strategies need different setups. If you want to trade a credit spread, you will usually have to search for something else than if you, for example, want to trade a calendar spread.

Step 2: How To Find An Actual Underlying Asset?

In the high probability option trading style, the underlying assets aren’t as important as in other trading styles. That’s because high probability option trading is based on probabilities and statistics, whereas other trading styles are based on certain chart patters or similar. You can use technical or even fundamental analysis for this strategy as well, but you can also trade and be profitable without using these forms of analysis. As we aren’t looking for specific setups, chart patterns or similar, it is much easier to find new trade opportunities. There are certain criteria that should be met and as long as these criteria are fulfilled practically any asset can be used. The general criteria that always should be met:

  • Enough Liquidity: This means, the asset should have a high volume and a lot of open interest. With limited liquidity and volume come a lot of disadvantages. I presented the importance of liquidity in THIS ARTICLE. As a rule of thumb, I suggest only trading assets with at least 1 million of daily volume. But the more the better. A great example of an asset with amazing liquidity is SPY. The following picture shows the insanely high average daily trading volume of the SPY ETF.spy etf volume Don’t only look at the volume of the actual underlying stock/ETF…, look at that of the options as well. If the asset has millions of shares traded on a daily basis, but only a few options are traded per day, you shouldn’t trade it. There should be enough volume and open interest on many options on the option chain. Also, the options volume and open interest is extremely high for SPY as seen in the picture below:’

spy daily options volume

  • Availability of options: Another important factor to check is the availability of options. Does the underlying even have options? If yes, how many? If an underlying only has options with unpractical expiration dates or only with a few strikes, they are kind of useless for most strategies. So make sure that there are many different options available.

 

  • Implied Volatility (IV): Look at implied volatility as this is very important for many option strategies. Overall long option strategies should ideally be entered in a low IV environment as they profit from a rise in implied volatility (positive Vega), whereas short option strategies should be entered in a high IV environment as they profit from a drop (negative Vega). To find out if IV is currently high or low, you should use IV Rank. IV Rank shows the current state of IV compared to historical figures. As an example, an IV Rank of 75 means that IV has been lower than it currently is 75% of the time. In other words, an IV Rank of over 50 means that implied volatility currently is high and under 50 means that it is rather low. Optimally, you should thus open short strategies when IV Rank is above 50 and enter long strategies when IV Rank is under 50. Tastyworks and other similar brokers display IV Rank directly next to the ticker symbols. If you are interested, you could check out my Tastyworks review.

 

  • Last but not least, you should look at special events like earnings, dividends and more. If not factored in, these events can often ruin an otherwise perfectly good trade. Prices often tend to move differently near and during these and other special events. So if you aren’t doing a specific earnings strategy, try to avoid underlying assets that have earnings or something similar coming up. To do this, you could either do a quick google search of the ticker or check the current and upcoming events/news on market watch sites like Yahoo Finance, Google FinanceMarketWatch

Checking all these things is very important and may seem like a lot of looking up. But it really is not. To prove that, I want you to take a closer look at the picture below displaying one of the standard watchlists in the broker platform Tastyworks: tastyworks watchlist features 2018

As you hopefully can recognize ALL of the general criteria and more can be read directly from this tab. All you need to find potential trade opportunities is go to the watchlist tab, select the pre-set watchlist ‘High Options Volume’ and order it by descending/ascending IV Rank. Then all you have to do is select a ticker and its earnings date will be displayed on the right-hand side together with a preview of the chart and more. To learn more about Tastyworks, click HERE. The next essential factor to consider is position sizing and your trading account size. I usually do not recommend risking more than ca. 5% of your total account capital per options trade. Therefore, you obviously can’t trade the same assets in small accounts as you can trade in big accounts. Thus, the selection process is different depending on your account size. In smaller accounts, you will need to trade overall cheaper assets/securities. Here again, don’t only look at the asset’s price itself, look at the options as well. Often more expensive assets can still have cheaper options. Additionally, you could try to focus on bigger indexes as these often are cheaper, more liquid and offer built-in correlation.

While trading with a smaller account, I learned that you can’t trade too small either (entire article on trading in small accounts, HERE). Therefore, the 5% limit can be adjusted in very small accounts. For short strategies, it doesn’t make sense to trade if you don’t take in enough credit. For simple credit spreads, I set myself the rule to always take in at least $30 of credit per spread. With commissions, it is otherwise not really worth it, even though my broker, Tastyworks does offer very low commissions ($1 per contract when openings, $0 when closing positions). A few example tickers that I use for my secondary small account are; QQQ, IWM, FXE, SPY… In bigger accounts, you aren’t nearly restricted near as much as you are in small accounts. Basically, you can trade all the more expensive assets and the cheaper assets. This has advantages, but a few disadvantages as well. As you have the opportunity to trade bigger companies now, you should definitely select as uncorrelated assets as possible. This is the only way to hedge against bankruptcies and other ‘unpredictable’ events.

An example for this would be to trade both companies in the energy sector and the social media sector. These two industries aren’t very correlated at all. So once again, look at your current portfolio and let that influence your decision on which asset to trade on next. A few companies with a little more expensive stocks are; AAPL, AMZN, GOOG, TWX…   After doing all this, you may still choose to do technical (or fundamental) analysis to make a directional assumption or whatever. It can potentially improve your win rate, but it is not necessary for high probability options selling.

Step 3: Setting Up The Trade

Before you can send out an entry order, you now just have to set up your trading strategy. This shouldn’t be too hard as the most work already is done. How you do this mainly depends on what strategy you chose. Therefore, I can’t say too much here. But I can definitely say that your account size plays a deciding role once again. In bigger accounts, you could do wider spreads to increase the max profit (and loss), trade more contracts and so on. One further tip is to choose options with a lot of volume or open interest for your spread. On option chains, you should notice that some strikes have more volume than others. Choose these strikes for your spread if it makes sense. But don’t change your entire strategy just for the sake of a little more volume. Use some common sense here. Only choose these options, if you have to move your strikes by one or two max. After setting up the trade and double checking everything just to be sure, you are ready to send out the (limit) order at the correct price.

Recap

To recap, when finding underlying assets to potentially trade option strategies on, you should follow these steps:

  1. Find out what position your portfolio needs to become more neutral
  2. Find an underlying with enough liquidity, available and liquid options, the correct IV level
  3. Check option prices and compare to account size
  4. Look up if the asset has upcoming events like earnings
  5. Set up trade
  6. Send order at the correct price

 


This Article is part of the Intermediate Option Trading Course. If you are reading the article as a part of the course, you can continue to the next lesson: HERE

 

6 Replies to “How To Find New Potential Trades – Step By Step Guide”

  1. Hello,
    I picked your post hopping to learn a bit about option trading basics even though your post is about finding new trades. In that sense, you go right into the subject and it’s very technical. you describe all the steps with thorough explanations. I really like the fact that you provide a recap of all the steps at the end of the post. my critic is if you’re not a a seasoned option trader it’ll be hard to follow the explanations. Otherwise it’s very good material. I have some knowledge in forex and stock trading. Options is kinda the last boundary for me. If it ever crosses my mind to try it, I’ll know to come to your site to get good training if you allow.
    thanks for a well documented site.

    1. Thanks so much for the feedback.I really appreciate it. I can completely understand that this post may be a little hard to understand for beginner option traders. I guess you weren’t reading the article as part of the intermediate course. This article is actually part of a course. In total I currently offer three courses starting with beginner and ending with advanced. So beginners should ideally start with the beginners course. If you want to check out the courses, you can see their outlines, HERE.

  2. Hi Louis,
    Thanks for your post on this. I thought I knew a thing or two about options and then I read your really informative article and realized I need to go back to school on this topic. Really insightful but it highlighted that as a beginner, there are a few more fundamentals I would need to understand in order to invest more in options. Thanks again for the article!

    Cheers
    James

  3. Hi Louis,
    First of all what a excellent website! It’s packed full of great information on options trading and a must read for anyone looking to learn more about trading options.

    I did a little options trading in the past but only on a demo account with Optionsxpress. I was placing itm covered calls and had some great results.
    I currently don’t have a large enough amount of capital to start trading for real but could I start with a small amount first and build up my capital?

    Thanks

    1. Hey Christian,
      Thanks so much for the kind feedback. I really appreciate it!
      Starting with limited capital trading is a great idea. On the one hand, it is a great way to get used to trading with real money without risking too much and on the other hand, it is possible to grow the account size. Nevertheless, you shouldn’t expect too much. You won’t turn a $2000 account into a $100 000+ account with simple options trading anytime soon.
      That said, you can always add more money to an account later down the road. It’s a good idea to test out strategies with a smaller account. Rather start with a small account than with a too big account. Never risk risk money that you can’t afford to lose.
      Paper/virtual trading is also a great way to try out some strategies. But there is still a difference between risking real and paper money.
      Hopefully, this helps. If not, please let me know!

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