The Real Cost of Option Credit Spreads

07/06/2015 8:00 am EST

Focus: OPTIONS

Josip Causic

Instructor, Online Trading Academy

Josip Causic of Online Trading Academy answers option trading questions regarding credit spreads and daily watch lists.

Occasionally, I write articles answering students' questions on various topics regarding options trading. First I will address a student's concerns regarding commissions when it comes to credit spreads. Then I will address a question about watch lists and how many lists options traders really need to be successful.

The first question concerns the issue of credit spreads. Basically, the student's biggest concern was the fact that selling a short vertical spread on an ETF brings in so little premium and that out of the credit premium, the commission needs to be paid before one could state that the trade was worthwhile.

My comment to that observation is-yes. The observation is accurate and correct. A trader ought to count in the cost of commissions; it is simply a part of the "game."

However, for those who have been around for awhile the cost of commission today is laughable in comparison to what it used to be. When I was starting, I actually had to figure the cost commissions into my Profit and Loss prior to the entry.

Back then, there was a ticket charge plus the commission per contract. Not that the remnant of that legacy is completely dead today: for instance, some brokerages are still charging, on average, a ticket cost of 9.99 plus 0.75 per contract. Hence, if a trader is considering a trade only with single units, then the calculation would be the following: the cost of long call premium plus (9.99 + 0.75) $10.74 to get in and also $10.74 to get out.

Hence, to be profitable the long call must make (2?10.74) $21.48 just to break even. Knowing this prior to the entry, a trader really has to be quite convinced that his long directional call is going to increase in premium within the time frame of the contract he or she has purchased.

However, if the trader chose a short vertical (which has two option contracts), then the commission cost is (9.99 + 0.75 + 0.75) $11.49 if the trade is entered as a spread trade. If it was not entered as a spread but rather as "legging in," then the commission structure is slightly different.

Let us assume that first the long leg is purchased. This would have commissions the same as the earlier example of a long call (9.99 + 0.75) $10.74. Once the long leg was filled, the trader could then sell a short call against the long call creating a spread. (In this case whether the trade is short vertical, long vertical, diagonal, or horizontal is not a part of discussion.)

The short trade would again generate the same type of commission (9.99 + 0.75) $10.74. This is how things used to be prior to the brokerage companies coming up with spread trading platforms. Now compare legging in versus opening a single spread in the following table.

chart
Click to Enlarge

Keep in mind that if these two trades were to be exited, there would also be commissions for exiting.

Next: Butterflies and Iron Condors

|pagebreak|

Next let us move a notch higher, to Butterflies and Iron Condors. These option strategies are four-commission creatures, and that is just for the entry. Hence, it is easy to see how the student who e-mailed really has a valid point.

One of the best ways to deal with this issue is by choosing a brokerage company that does not charge a (hateful & outdated) ticket charge but only a flat per-contract fee. For instance, Trade Station charges OTA students $1 per contract initially, and then at month's end it reimburses 20% of the commissions in the form of a small credit in each trader's account. This brings down the commission to only 80 cents.

In short, the commission structure in general has dropped quite significantly from what it used to be, yet it still needs to be taken into account.

Another question I received concerns a different issue: a watch list; or should I say watch list(s)-plural. Way too many students come to us with multiple watch lists each containing dozens of candidates. Just ask yourself, "Is this efficient?"

The goal of trading education is to enable oneself to accomplish more while doing less. Having many different watch lists is often counterproductive. Less is more.

Let me emphasize the point this way: Remember that trading options involves much more than just looking at the technical chart, right? Though that might come as a shocker for novice traders, those who have attended the Online Trading Academy Professional Option Trader course know about our check list that looks at Open Interest (liquidity), strike increments, and the width of the Bid/Ask spread.

Even if the stock, ETF, or an underlying asset qualifies for a directional trade from technical analysis, one of these items on the check list might disqualify it. Hence after so many weeks, or even months, of "searching for candidates" and weeding out the ones that don't meet the check list rules, an option trader will come up with only a select few assets to trade. These few qualify by the check list requirements week after week, month after month.

Then the question becomes why even bother wasting time searching for more candidates. In my humble opinion, one should have only three watch lists: one for bullish setups, one for bearish ones, and the in-betweens, meaning range-bound. Those are the only three watch lists needed.

In conclusion, we have addressed two very different areas involved in option trading. Option traders do need to take into consideration the commissions they are paying in relation to the profits they are taking in, especially on out of the money credit spreads. Fortunately, the commission structure has changed to benefit traders in recent years. Make sure your broker offers a fair commission structure.

We also discussed being efficient with our watch lists and option selection. These are two of the many areas that a trader should be aware of as they embark into the realm of trading options.

Josip Causic is an option trading instructor at Online Trading Academy.

Related Articles on OPTIONS