This Can Ruin Any Option Trade

09/06/2012 8:00 am EST


J.W. Jones

Chief Options Strategist, Technical Traders, Ltd.

JW Jones of Options Trading Signals highlights one aspect of the underlying that can have a negative impact on your trade regardless of the technical picture.

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, Hotel California: "You can check-out any time you like, but you can never leave!" 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 benchmarks 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 cents or less for "normal" stocks such as Exxon Mobil (XOM), Caterpillar (CAT), or Goldman Sachs (GS). For "super size" stocks such as Apple (AAPL), Google (GOOG), or Amazon (AMZN), spreads are a bit wider, but typically around 25 to 30 cents or less.

In stocks with lower price points that have very liquid option series, such as XOM and Intel (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, 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- to 4-cent spread that may exist in the most liquid series. Ultimately, these strategies will not work-the market maker's kids need to eat too.

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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 $562 a share. It may be ready for a pullback, or at least a period of price consolidation, before resuming its course.

Next: What to consider


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 cents.

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 credit. The aggregate bid-ask spread for this is 60 cents-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 60c 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 Strayer Education (STRA):

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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.

JW Jones can be found at Option Trading Signals.

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