The process of identifying these opportunities has a set of steps that are a bit different than those for expensive options. Here, rather than selling, we will be buying options. We’ll buy calls if we’re bullish or puts if we’re bearish, though it’s more complicated than this.
Here’s what we need to do to take advantage of cheap option opportunities. First, I listed the steps. Then, we’ll walk through an example and describe each step.
1. Locate stocks with unusually low implied volatility (IV) relative to their own IV history. Low IV means cheap options.
2. Using a daily price chart, determine if we have a good reason to be strongly bullish or strongly bearish on each stock. This will be the case only if the stock is near (within an average day’s range of) a high-probability turning point – a high-quality supply or demand level. Furthermore, there must be plenty of room for the stock to move after its reversal, enough for at least a 3:1 reward-to-risk ratio. Reject all the stocks that fail this test. This will eliminate most of the possibilities. The remaining stocks, if any, are our best opportunities.
3. Identify the stop price that we would be using if we were going to trade the stock itself. At what price would we exit the trade if it went against us?
4. Identify the target price for the next 30 days. At what price would we take our profit and exit the trade if it went our way during that time?
5. On the stock’s option chain, locate the nearest monthly expiration date that is more than 90 days away.
6. For that expiration date, find the first in-the-money ( ITM ) strike price. If we are bullish and using call options, that is the next strike price below the current stock price. If we are bearish and using put options, it is the next strike price above the current price.
7. Calculate the profit amount with the stock at the target price and IV unchanged 30 days from now. You must use option diagramming software for this.
8. Calculate the loss amount with the stock at the stop price and IV unchanged 30 days from now. Reject the trade if the 30-days-out reward-to-risk ratio is less than 2 to 1.
9. Recalculate the 30-days-out-profit-and-loss amounts and the reward-to-risk ratio assuming that IV increases back to its one-year average. Reject the trade if the reward-to-risk ratio is not at least 3:1.
10. If all still looks good, place the trade.
11. Enter the order(s) to unwind the trade if the underlying hits the stop price