One of the traps for budding options traders is to attempt to apply
various strategies to any underlying that exhibits a familiar technical
pattern. This is a mistake. Option trading strategies must only be
applied to underlying assets that have very liquid options.
To attempt to trade thin options puts the trader at serious risk of
the situation the Eagles described in their signature song. You may be
able to negotiate reasonable prices to enter the trade, but your exit
will not reliably be so easy to exit due to low volume levels and
generally wide bid / ask spreads.
So what are the bench marks that allow the new trader to recognize
what are liquid options and what are not? Perhaps the easiest
fundamental characteristic of an option that is liquid is to glance at
the bid / ask spread of the front series option at-the-money strike.
These strikes will almost always be the most active series and have the
tightest bid / ask spread.
In the modern world, that spread should be 6¢ or less for “normal”
priced stocks such as XOM, CAT, or GS. For “super size” stocks such as
AAPL, GOOG, or AMZN spreads are a bit wider but typically around 25-30¢
or less.
In stocks with lower price points that have very liquid option series
such as XOM and INTC, it is not uncommon to see markets quoted a penny
wide during periods of relatively calm markets. However, and this is an
important point, in times of market turmoil, the spreads typically widen
much beyond their normal size. In severe market turmoil the spreads may
reach a point even in liquid underlying assets that precludes any
semblance of reasonable ability to execute trades.
The higher-priced underlying assets such as GOOG, because of their
characteristically wider spreads, are more easily executed at negotiated
prices in which the bid ask spread is reduced. This is particularly the
case on multi legged positions; the spreads usually give the counter
party, in this case our beloved option market makers, a straightforward
way to hedge their risk. For this the trader will often be given a
discount.
The rule of thumb for calculating this discount is to reduce the
aggregate bid / ask spread by one third. A corollary of this is not to
waste your time trying to negotiate out the total 2 – 4¢ spread that may
exist in the most liquid series. Ultimately these strategies will not
work – the market maker’s kids need to eat too.
Let us look at a practical example of what might be an appropriate
starting point. Consider GOOG, one of our super sized stocks that
recently trades on average a bit over $33 million of options per day.
GOOG has recently climbed to multi year highs in a parabolic move
with a very aggressive angle of attack and currently trades a bit over
$678 / share. It may be ready for a pull back or at least a period of
price consolidation before resuming its course.
For those who agree with this hypothesis and may be considering an
actionable idea, consider the September 680/685 call credit spread, a
bearish play. This spread is constructed by selling the September 680
call and buying the September 685 call. As is readily apparent from the
option chain, the bid ask / spread for each of these is 30¢.
To introduce another term useful for options traders, consider the
“natural” price of this spread. You would sell the 680 strike at the
quoted bid, $14.10 and buy the 685 strike at the quoted price of $12.10
for a “natural” price of $2.00 credit. The aggregate bid / ask spread
for this is 60¢ – the sum of the spread for each of the two legs.
Using our rule of thumb to expect a 33% discount on such spreads, we
should be able to execute the spread for a net credit of $2.20 ($2 plus
one-third of the 60¢ spread). This obviously increases our net credit
and potential profitability by 10% and would result in significant
improvement of trading results over a series of similar trades.
Just so you have seen an example of an options board in which the
Hotel California syndrome could be expected to occur, consider the
pricing in this option chain for symbol STRA:
As you can see, the spreads for the 65 strike, the current
at-the-money strike, are in excess of $1. Stay away from these sorts of
traps; the only one who can make money with any reasonable probability
is the market maker.
The point of today’s missive is that you should choose carefully the
field on which you wish to play. Careless selection of the underlying to
trade can put you at a significant disadvantage regardless of the
attractive chart pattern of the underlying stock in question.
Happy Trading!
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