“You can check-out any time you like, but you
can never leave!”
~
“Hotel California”, The Eagles ~
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 Call
Option Chain
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:
Options
Trading Strategies
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!
JW
Jones
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