If you’ve ever flown a plane, or flown in a plane actually, you know that the captain doesn’t step into the cockpit at the last moment, hit the “takeoff” button and sail off into the sky. Not only have there been many hours of pre-flight preparation, from the flight and maintenance crews to the traffic control center, but the pilot has also gone through a rigorous pre-flight checklist.
Options traders, too, know the value of preparation and the value of a checklist. And though each of us may have our own routine, many follow the same general outline. Eager to hit the wild blue yonder? Let’s get ready.
The following, like all of our strategy discussions, is strictly for educational purposes only. It is not, and should not be considered, individualized advice or a recommendation.
Before taking off, the pilot does a visual walk-around of the aircraft and assesses the situation, highlighting any potential aberrations or trouble spots.
For an options trader, this is similar to the morning market check. What’s happened overnight in the overseas equity markets? How about the futures markets— gold, oil, bonds, U.S. stock indexes, currencies and such?
After you’ve assessed the macroeconomic environment, you can consider moving to the micro environment— the specifics of the stocks or sectors in your portfolio or on your watchlist. Has there been any news today on the companies you’re watching or their competitors? When is the next earnings release and projected dividend?
For an options trader, one critical pre-flight checks is on implied volatility (IV). How does today’s IV compare with historical volatility? Assessing options prices in the context of implied versus historical volatility might help you gain perspective.
In short, the walk-around can be the first step in helping you assess the market and formulate your opinions.
The Flight Plan
Once the pilot has completed the pre-flight assessments, it’s time to dial in the flight plan. What’s the destination, and how do we plan to get there? For the pilot, it’s about communicating with air command to find the safest and most efficient way to get from point A to point B.
For the options trader, it can be about assessing the relevant risks, and determining a strategy that can help position you for sufficient reward potential relative to the risk you’re taking or to mitigate the risk of a currently held position. In our daily Swim Lessons program, co-host Scott Connor and I assess different market scenarios and then explore potential options trading strategies for those scenarios. In a recent article, we highlight three key elements to consider when choosing an options trading strategy:
- Defined risk— how to potentially limit your risk of loss to a maximum amount, High probability— as explained in a recent primer, Positive time decay— strategies that can help the passage of time to work for you.
OK, so you’ve done your assessments and dialed in the strategy, so you’re cleared for takeoff. Do you switch to auto-pilot and settle in for a nap? Not exactly. The pilot, as well as the options trader, should keep the seat belt fastened and remain vigilant for unexpected changes in the weather, because you never know when a shift in the flight plan might be in order.
Markets, like the weather, are constantly changing, and though the instruments we use to gauge probabilities can be pretty accurate, they’re still just that— probablilities— and unlikely events do occur from time to time. Staying vigilant and flexible, however, can help you weather any storms that pop up, or maybe help you steer around them.