When I look for an option trade, I have several rules to find the better trades. I happen to like

Quest Diagnostics

(DGX) - Get Report

because of its low P/E ratio of 13x earnings and will use the options as our example. The stock is currently trading at $54.34, as of ~3:00 p.m. EST.

The Rules:

1. Look at the Implied Volatility of each option. We want to buy low implied volatilites and sell high implied volatilities (IV) -- Trading 101. DGX stock has a recent actual volatility of 22%, so we will keep that in mind for reference, but it is good to remember that what is really important here is the relative IV if we are doing a spread.

2. Direction of the option play should agree with our bullish or bearish opinion on the stock. To check this, we will look at the net delta of our spread. A positive delta is bullish, negative is bearish.

3. Sell time premium. For this we parameter, want to look at the theta. For a spread or option play we would like to have the net theta on the trade be negative. This simply means that the trade is making money every day we are in it even if the stock stays where it is. It is much easier to predict that December will have 31 days than the price of the Dow on December 31.

These are not the only rules but they are the basics.

The Greeks for the May calls are:

May 50 call 22%

May 55 call 23%

May 60 call 21%

Looking at DGX, we find that we can sell the May 55 call with an IV of 23% about in line with historical volatility. However, we can buy the May 50 call at 22% volatility and the May 60 call for 21%. Recall that each option has its own IV and each option price has its own IV. Thus, there is a different IV for the last and the bid and ask prices on each option. Our conclusion is that a butterfly is the best way to play this IV setup.

In the line in the preceding table labeled "Butterfly Net", the respective columns have been added up with respect to whether the position is long or short that option. The butterfly net also takes into account the fact that two May 55 calls are sold in a butterfly.

We see that the net delta is positive consistent with my bullish notion on the stock. We also see that the theta is a nice +.0041 so this trade will pay us a nice +.0041 to hold. The bottom line is that this trade meets my criteria and is a go. We will set the stop profit at $55.00.

Trades: Buy to open 1 DGX May 50 call for $5.70, sell to open 2 DGX May 55 calls at $2.95 and buy to open 1 DGX May 60 call for $1.05.

The net debit is $0.85.

At the time of publication, Phil McDonnell held no positions in the stocks or issues mentioned.

Phil is a professional options trader and contributes regular commentary to the Daily Speculations web site. Prior to trading professionally, Phil was a software developer for Dollar/Soft, a financial software company specializing in options software for equities, indexes and futures. He also wrote the book, Optimal Portfolio Modeling, which was published by Wiley Trading in February 2008.

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