JW Jones of Options Trading Signals explains that by choosing the most liquid options, traders can improve their profit potential, but perhaps more importantly, can easily exit positions that turn against them.
Welcome back to the musings from the desk of an options trader. I wanted to discuss some important facts readers should keep in mind when considering an options trade.
There are lots of ways to make errors in my world, and I think I have made most of them. I suggest you at least consider the points I will discuss because each has cost me a lot to learn and I would like to save you the expense and frustration. After all, errors are inevitable, so at least make (and then learn from) ones that you have not been warned about.
Be forewarned that there is a voluminous set of specific data that derives from the various pricing parameters of options. The several data points for stock trading only require inputs of price and volume. Option datasets as a necessity include parameters of volume, implied volatility, and time to expiration. Each of these datasets exist for the various strike prices in each and every of the various expiration months available for trading. The data compilations are huge.
The magnitude of the data available is overwhelming in its entirety. It is for this reason that the options trader must approach each trade with a specific price, time, and implied volatility hypothesis.
One of the most important considerations with options is that of liquidity. Option volumes can vary dramatically between the various underlyings available. Consider the case of Apple (AAPL) options which have trading volumes in excess of several millions of dollars each and every day; this is to be contrasted to the numerous underlying stocks having thinly traded options that trade only occasionally and by appointment only.
I believe that it is important to restrict your focus to stocks having options that reliably trade consistently and in significant volume. Buying and selling thinly traded options leaves you at significant risk of suffering from “Hotel California” syndrome: “You can check out any time you like, but you can never leave.”
It may be possible to negotiate a reasonable price to enter a position, but if you need to exit, you can expect to leave a pound or more of flesh on the table. Only bad things typically happen when trading these Kate Moss thin series; I strongly suggest that you avoid them like the plague.
Another benefit to using liquid series for trading is the fact that these issues generally have minimal slippage. It was not that long ago that a tight bid/ask spread was considered to be anything under 25 cents. In the current environment of options trading, quotes in actively traded series routinely display spreads of two to three cents. This is where you want to live and work.
The drag produced by egregious spreads dramatically increases your trading “friction” and results in leaving behind potential profits to fund the market maker’s ski chalet in Aspen.
See related: An Option Signal Market Makers Count on
These missives are directed at those traders beginning to visit my world of options. As new visitors, I would like to see you test the waters gently in order to determine if you would like to become our new neighbors. While a host of proprietary sites exist and provide invaluable data to the experienced trader, there is less discussion of the free sites for those of you taking our introductory tour.
As a suggestion, I find the free resources of the Chicago Board Options Exchange (CBOE) to be excellent. Today’s discussion has focused primarily on selecting only those options which are most active and liquid for trading.
An excellent place to start in order to find the most liquid options is the list of options available for trading the weekly option series. This diverse group represents a small portion of the entire options universe, but has been selected to include only the most actively traded series.
I will get to specific discussions of the peculiarities of weekly options in future postings. For now, suffice it to say that the series included in the weeklies are the most liquid and the place to which the aspiring option trader should direct his attention.
See related: The Newest Innovation in Weekly Options
The list of underlyings which have weekly options can be accessed for free as a downloadable Excel file from the CBOE here.
By JW Jones of Options Trading Signals
