My 3-Point Checklist for Every Options Trade

Over my 40-plus years in the markets, I’ve learned that good trading isn’t about trying to predict every move. It’s about finding situations where the odds are stacked sufficiently in your favor – and knowing exactly what you’re risking if you’re wrong.

That’s particularly important with options. Before I enter an options trade, there are three things I’m looking for: clearly defined risk, sufficient potential reward, and a reason for the trade to work within the available time frame.

If I can’t get comfortable with all three, I’m happy to sit things out and wait for another opportunity to come my way.

The first one is especially important…

When I buy an option, my maximum loss is limited to the premium I’ve paid. If I buy an option for $3, for example, then I’m risking $300 per contract (an option contract is for 100 shares). That allows me to know my maximum potential loss before I ever enter the trade.

But defined risk alone doesn’t make something a good trade. That’s where the other two factors come into play…

Make Sure the Reward Justifies the Risk

Let’s say I’m considering buying an option that costs $3. If I think the most I can realistically make is another $1, I’m risking $3 to potentially make $1. That’s not the type of risk/reward relationship I’m usually looking for.

Instead, I want situations where a relatively small amount of capital can potentially generate a much larger return if my analysis proves correct.

That doesn’t mean every trade needs to double or triple. The potential reward I’m looking for depends on the setup, probability of success, and how much I’m risking.

But there has to be enough upside to compensate me for doing the trade. That’s something new traders often overlook…

They become so focused on whether a stock is going up or down that they forget to ask whether the potential payoff is worth the risk they’re taking on.

Professional traders think differently. Before putting money on the line, I’m thinking about what happens if I’m right, what happens if I’m wrong, and whether the relationship between those two outcomes makes sense.

But with options, there’s another complication. It’s not enough to be right. You also need the move to happen within your required time frame.

Have a Reason for the Move to Happen Now

Unlike shares, options have an expiration date. That means I don’t want to buy an option simply because I believe a stock looks cheap or expensive and hope that eventually the market agrees with me.

I want a setup or catalyst that gives me a reason to believe the move could happen before my option expires.

That catalyst doesn’t necessarily need to be a single event such as earnings or a Federal Reserve meeting. It could be a technical setup, an overbought or oversold condition, an extreme move I’m expecting to snap back the other way, an important economic release, or a shift in volatility.

What matters is that I have a reason for entering the trade now.

Because every day an option sits there without the move I expected playing out, time is working against me. That’s theta – or time decay – gradually reducing the value of the option as expiration approaches.

And that’s why these three elements work together. Defined risk tells me what I can lose. Potential reward tells me whether the trade is worth taking. And the setup or catalyst tells me why the opportunity exists right now.

Take away any one of those, and the trade becomes much less attractive. That’s also why I don’t feel compelled to trade every day.

The smartest thing you can do is wait until all three things line up. The objective isn’t simply to find a trade. It’s to find a trade where the potential reward justifies the risk – and where there’s a clear reason for that opportunity to play out within your required time frame.

That’s what I’m looking for before I consider putting my money to work.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict