In How Can The Average Guy Succeed Trading Options? I wrote about how there is no minor leagues in options investing… whether you’re a raw rookie or a seasoned pro… we are all trading in the same markets.
The great thing about options investing is that it’s still a relatively new investment vehicle. Sure, they’ve been actively traded on the exchange since the 1970s…however, the last 5 years has seen a real jump in interest.
2. In How Can The Average Guy Succeed Trading
Options? I wrote about how there is no minor
leagues in options investing… whether you’re
a raw rookie or a seasoned pro… we are all
trading in the same markets.
3. The great thing about options investing is
that it’s still a relatively new investment
vehicle. Sure, they’ve been actively traded on
the exchange since the 1970s…however, the
last 5 years has seen a real jump in interest.
4. What once seemed like a mystical product is
now becoming more mainstream.
5. Of course, media coverage and advancements
in technology have played a major role. Retail
investors have access to the same tools as
professionals. This includes user-friendly
execution platforms, research and analytic
tools.
6. The brokerage industry has recognized this by
offering more competitive commission rates
for option investors.
7. With increased investor participation comes
more competitive markets. Some stock
option spreads are only a penny different
from the bid and the ask spread. Not only
that, but there are also short term
opportunities through the use of weekly
options.
8. Option investing allows you to hedge risk in a
stock portfolio…but it also allows you to
express investment ideas with less use of
capital. Because options are leveraged
products they give the investor an
opportunity to make an obscene amount of
money… sometimes in a short period of time.
9. With that said, if you’re not familiar with how
options move and don’t have the basics
down…you could also lose money very
quickly.
10. That’s why I have created a great list of
articles for you to review, read & learn.
11. Now, if you’re making the transition from
stocks into options or have been using them
for a while, I have some important advice to
share with you.
12. At the moment, there is probably only a
couple hundred of options that offer
competitive bid/ask spreads. That means not
everything is really tradable and you should
be selective with which stock options you
choose.
13. Here’s a likely scenario, you might look at a
stock chart and have a bias on direction.
14. Instead of buying or selling the stock, you can
use options to reduce the amount of capital
required, which helps reduce your risk
exposure and gives time to see the trade
work out without the fear of getting stopped
out.
15. However, just because options have their
obvious benefits, you still want to put
yourself in a position to be profitable if your
idea is right.
16. How do you do this? Well, first what you
want to do is open up an options montage.
This is just industry jargon for a list of
tradable options in a particular stock or index,
categorized in expiration periods and option
strike price.
17. In addition, you’ll get live quotes, the bid/ask
spread, last sale, option greeks, implied
volatility, volume and open interest.
19. In the beginning, you want to focus on the
volume and open interest.
20. Now, volume refers to the amount of option
contracts traded that day. Open interest
refers to the number of outstanding option
contracts that are still open. Each expiration
period and strike price have their own volume
and open interest statistics.
21. Ideally you want to get involved with
something that either has a decent amount
of trading volume that day or open interest.
Why? The answer is simple… unneeded
transaction costs can kill a great investment
idea.
22. For example, on September 8th 2014,
Emergent BioSolutions (EBS) was awarded a
$29 million contract for development of
vaccine formulations effective against NAID
priority pathogens.
23. With Ebola outbreaks happening in several
parts of the world, it’s become one of the
most talked about topics in the media and
news today.
24. Now, let’s say that you believed a mini bubble
will occur in companies that are linked to the
Ebola story, driven by speculators trying to
catch the next hot stock.
25. When we pull up the options montage,
you notice that EBS has options and they
want to buy calls to express a bullish opinion.
26. With the stock trading around $22.65 per
share, the $22.5 option strike is the closest to
the ATM price.The September $22.5 call had
zero volume and 10 contracts of open
interest.
28. What’s worse is the spread was $0.10 bid and
offered for $4.90.
30. Two things here, you’re either the smartest
investor who trades options or there is
something wrong.
31. Why? Because no one else has this
opinion…not saying that it’s impossible that
these options couldn’t draw more
interest…however, no one has yet to share
your same view yet.
32. Moving forward, check out this spread $0.10
bid at $4.90 offered. That shows you that
there is very little interest in these options
and the option market is not competitive at
all.
33. Most likely you’ll have to pay close to the ask
price when you enter and when you exit
you’ll have to sell your contracts close to the
bid price. This is also referred to as slippage.
34. Let’s say you trade one contract like this
once a week.
35. Let’s say you lose $.15 in premium every
trade (being generous with that, it’s probably
worse) for one year. That’s $780 a year you’ve
lost on just that one measly contract.
36. Now, if there is no recent order to price
check, it’s hard for you to get a feel of what
you should be buying or selling at. One way, is
to try to “make the market” yourself.
37. Let’s say you wanted to buy 10 contracts of
the September $22.50 calls.
38. You’d place a bid slightly above the highest
bid. In this example, bid $0.15 with one
contract. Most likely, the electronic market
makers will join you by raising their bid to
$0.15.
39. You could work yourself up until the market
makers stop joining you. For example, let’s
say at $1.50 you are the only bid. The market
makers are telling you that they are not
willing to pay for it at that price.
40. By doing this, you’ll get a better feel of where
the market is. This is much better than
guessing and possibly paying too much for
options. In any event, these types of option
investments should be eliminated if you’re
new to options.
41. You’ve got to put yourself in a position where
the probabilities are in your favor. If you’re
buying options like this, slippage and
commission costs will push your break-even
farther away and decrease your chances of
becoming profitable.
42. By the way, the market makers are not trying
to screw you, they are just trying to make
money off the bid/ask spread. Without
competition or demand, it’s just you and
them.
43. Imagine going to the stadium to watch a
professional football game and wanting to
grab a beer. Guess what? Beer is expensive
because there isn’t a lot of competition inside
a pro stadium.
44. That means you have to pay up in order to
enjoy a beer at the stadium. However,
outside of the stadium, you can go anywhere
to buy beer, places like grocery stores, deli’s,
retail warehouses, beer and liquor stores.
45. They are all offering the same products and
competing for your business. Because of this,
prices are much lower than inside an arena or
stadium.
47. You’ve got to take all of this into account
when you’re trading options. Ask yourself,
can this trade make money even with all that
slippage?
48. In most cases, buying call options under these
conditions is a losing proposition.
49. Selling premium probably makes the most
sense. By selling premium, you’re betting that
the underlying doesn’t reach a certain price
or stays in a range…in certain situations
buying premium could be
more profitable…however, slippage doesn’t
destroy your idea and the probabilities of
success are greater.
50. I’ve heard too many stories from traders
about how they got involved with something
that wasn’t very liquid…the position moving
in their favor but they either couldn’t get out
or the option premium didn’t move enough
for them to close out of the position for a
profit.
51. What you trade along with the strategy
selected is incredibly important.
52. Earlier I mentioned that you should always
look at the volume and open interest. Keep in
mind, that certain expiration periods might
have more volume and open interest because
of a catalyst, like an earnings announcement.
53. Make sure you’re aware when you’re stock is
announcing earnings. Trading earnings is a
completely different animal, to see what I
mean just read, “Don’t Trade Earnings Before
You Read This“.
54. In “What Are The Best Stocks To Trade Weekly
Options?“, I write about a technique that you
can use to check if the bid/ask spread in an
option is competitive. In the beginning, you
want to focus on options that offer a
competitive bid/ask spread.
56. The bid/ask spread changes for a number of
reasons. Those changes come from the time
decay element of options, movements in the
stock price and the changes in option
volatility. The first two reasons can be
explained easily.
57. However, option volatility could change
because of potential
news/catalyst…uncertainty. In addition,
supply and demand play a major role on what
causes shifts in option volatility.
58. The more demand for an option, the greater
the volatility rises and the more expensive
options become.
59. Think about it, if you are looking to trade an
option that no one else really trades…how
can you expect the bid/ask spread to be
competitive. There is no incentive for the
market makers to adjust the spread, they are
like the beer vendors inside the stadium.
61. In the EBS example, a market buy order for
those September $22.5 calls would have cost
$4.90 per contract. That means you’d need
the stock price to increase 21% by expiration
(less than 2 weeks time) just to break-even on
the trade.
62. With that said, limit orders are your friend. By
placing a limit order, you’ve decided what
you’re willing to buy or sell an option for.
You’re not at the mercy of the market maker’s
prices because you’ve defined your price.
63. That doesn’t mean you’ll get filled at your
price but you’ve defined your terms.
64. You see, if you’re used to trading stocks,
liquidity is usually not a big issue. However,
with options it’s something you’ll have to
focus on.
65. With that said, if you really like an idea and
liquidity is a possible issue…you’ll have to
look at alternative strategies like spreads,
selling options or using the stock instead to
avoid or reduce the role of slippage.
66. Without a doubt this is one of the most
common mistakes new option investors
make. Luckily it’s an easy issue to fix.
67. Here’s how you can avoid giving your money
away foolishly:
68. 1) Put your focus on options that offer great
liquidity. By observing the option volume and
open interest on an options montage you can
quickly identify what is worth trading.
69. 2) You’ll want to look at the bid/ask spread
and focus only on options that offer
competitive markets.
70. 3) You also want to avoid market orders and
execute limit orders when you start investing
with options. It’s tempting to try to get
involved in “hot stocks” that move…however,
if there is no liquidity in their options…you’re
likely going to have a tough time making
money.
71. Of course, there is more to selecting the right
stock options, stuff like understanding binary
events with options, defining risk before
entry and identifying if options are relatively
cheap or expensive. These topics will be
covered in detail in future posts for you.
72. By the way, have you ever gotten into a stock
option and gotten completely chopped up in
slippage costs?
73. If so, I’d like to hear your story. I’ll be hanging
out in the comments section below.
74. I almost forgot, if you’d like a more in detailed
introduction on how options can be used to
create better returns for you…make sure you
get a copy of Fearless Income For Leverage.
75. Join For Free To Receive My Ideas & Market Commentary I Only
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