Beware: This Kills Good Options Trades All The Time…
There are a number of variables that go into picking the right options contract. In previous articles, we’ve discussed the need to carefully select the right strike price and the right expiration date.
It’s also important to make sure that the option contract we select has plenty of liquidity and a narrow bid/ask spread. This ensures that we are able to enter (and exit) our position efficiently without losing money to slippage or poor market dynamics.
The idea of liquidity is very important for option trades. Liquidity measures how deep a particular market is — or more importantly, how easily a trader can buy or sell a material amount of stock or option contracts within that market.
Many traders who might otherwise be profitable wind up taking losses because of the lack of liquidity in their specific markets. For instance, let’s say an option price is quoted at $2.50. But the effective price drops to $1.75 by the time you exit all of your contracts. This means you will have a severely reduced profit (if not a loss).
For most well-known stocks, you can simply look at the “last” price to get a good idea of where the stock is trading and what you as an individual investor would have to pay for a full position.
But for option contracts, we have to be much more careful about verifying the price point at which we can sell our contracts. In particular, we need to look at what actually goes into a price quote for these options.
Analyzing Two Different Price Points
For any publicly traded instrument (including stocks), there are actually two prices that every trader needs to be aware of: the “bid” and the “ask” price.
Bid Price — The price market makers are “bidding” for a stock or option contract. In other words, the amount that the market is willing to pay for your stock or option contract.
Ask Price — The price market makers are “asking” for a stock or option contract. In other words, the amount that the market requires to sell a stock or option contract to you.
It is important to remember that when we are buyers, we look specifically at the “ask” price. And when we are sellers, we can expect to get paid the “bid” price when the sell order is executed.
Market makers typically make their money because off the spread between these two price points. For instance, an options trader on the NYSE may “offer” a contract at $1.50 and “bid” a contract at $1.45. This means that the market maker is willing to buy at $1.45 and sell at $1.50. His profit is the $0.05 difference between the two prices.
Whenever you set up an options trade, look specifically at the difference between the bid and the ask price as one metric to determine liquidity.
Tight vs. Wide Bid/Ask Spreads
A tight spread is one of the best indicators of a well-functioning, liquid market for an options contract. When there is plenty of competition in the market for a particular option contract (several market makers jockeying for position), we as traders reap the benefits.
Several different market makers competing to buy will lift the bid. At the same time, if there are market makers competing with each other to sell these same contracts, the ask price will naturally fall. The result is a very tight spread between the bid and the ask price.
For contracts trading with a price at or below $5, we like to see no more than a $0.10 spread. Often we can find setups with a spread that is $0.05 or less.
To put this in perspective, a $3 stock trading with a $0.15 spread can wind up eating into your profits significantly. If you sell a contract and then wind up buying that contract back to close the trade, the spread between the bid and ask is actually 5% of the notional value of the contract. And this is in addition to the commission fees that you pay your broker.
Even if you only sell the call contract (and then let the contract expire or be exercised), you are still essentially paying half of the spread.
A Liquid Underlying Stock Is More Important
If you listen to novice option traders, you’ll hear them talk a lot about “open interest” for individual contracts. Open interest refers to the number of contracts that are actually in effect at a given time.
For instance, if we decided to set up a covered call trade on a stock, we might buy the stock and sell the March $45 calls. Someone else (most likely a market maker) would have to take the other side of our trade and buy these calls from us. This new contract would increase the open interest of the March 45 Calls. If several people set up the same trade, the open interest would increase dramatically.
In today’s market, low open interest doesn’t necessarily mean that the option contracts are illiquid. Because of the trading technology and the number of market makers operating on the option exchanges, we can expect to have a relatively liquid options market provided that the underlying stock is heavily traded.
This is because market makers can quickly and easily buy the contracts from us and then immediately hedge their risk by selling the liquid stock. The entire process typically happens instantaneously, with computers handling all of the executions.
Action To Take
The key takeaway is to make sure that you are choosing liquid stocks that are actively traded. In addition, watch the bid/ask spread of the option contracts carefully.
And remember, if the spread is too wide for a trade that you want to set up, it doesn’t hurt to pass. There are will be plenty of chances to trade, and it just doesn’t make sense to compromise and put your potential profits at risk.
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