Fundamental Considerations When Trading Stock Options

Do the numbers tell it all? When you read something about a company, do you really believe it? How do you make a decision about what makes a good investment opportunity? For most traders, technical analysis takes center stage and some times the fundamentals are pushed to the back or forgotten all together. But there are some important fundamental factors that an option trader should always keep in mind.

1) Every trader or investor should know what is happening within the company and the industry to confirm why the stock or option is behaving as it is or if there are any possible events which could affect the stock or option price. Going to the company website and contacting the Investor Relations department is a good idea before entering into a trade. Its a little time consuming but this step may save you from any surprises and help to confirm your analysis. Of course, consider the source.

2) Investors and traders need to know when a target company comes out with financials such as earnings estimates, quarterly and annual reports and files SEC documents. The SEC regulations are designed to provide investors and traders with transparency. However, if a trader or investor isn't aware of SEC filings by a company, the trader-investor may overlook important information that is revealed in the required documents. A company could say "it was there for the entire world to see". It's caveat emptor, baby.

3) Option traders should be aware of "Triple Witching" dates. This scary sounding day is indeed something to avoid and it happens on every third Friday of expiration months. "Quadruple Witching" day happens when several types of options and other derivatives expire on the same day. This happens on the third Friday in March, June, September and December. Triple or quadruple witching days see volumes and volatility increase, which is largely due to investors "rolling" existing options positions to new expiration months and exercising option contract rights. With the advent of single stock futures (SSF) and improved technology, many feel that the Triple and Quadruple Witching days are no longer quite the chaos they were in the past. However, it's a good idea for the options trader to be aware of when the witches come out to play.

4) Decide if the stock and its options are overpriced. Look at the last 12 months price range for the stocks and see what the options have been doing in various expiration months. If the price is currently near the top end, consider buying on pullbacks.

5) Check the volatility of the stock. If it is above normal for the stock, there could be some information out there that's not readily apparent.

6) Check and see if insiders are buying or selling the company stock or exercising or selling options.

7) Review the Annual Report called the 10K or Quarterly Report (10Q) and particularly to the section usually titled " Management Discussion and Analysis" (usually in the front of the report). This will give a good synopsis of what the company management team feels about the state of the company and what future prospects are.

8) Check the company Income Statement and Balance sheets. The Income Statement (also called the Operating Statement) shows the profitability and expenses of the company operations and the Balance Sheet shows the financial strength of the company. If you don't know how to read financial statements, there are plenty of free sources to teach you.

9) Check out the competition in the Industry. How does the target company compare to its competitors? How does the company Price-Earnings ratio compare with that of the industry. The same holds for EBIT (Earnings before Interest and Taxies) profit percentage.

These suggestions should be part of an option trader trading due diligence and incorporated into a checklist from to be checked-off before entering into any trade. Trading strictly on the technicals could miss factors not fully discounted into price. Do both Technical and Fundamental analysis and then make your opinion.