If you are trading options contracts, you should consider a number of factors. Two very simple ones are commissions and liquidity. SPY (SPDR S&P 500 ETF) is one of the most liquidly traded options. By liquid I mean that the difference the bid/ask price as a percentage of the value of the option is small (this evaluation only pertains to out of the money option). Small would likely mean less than one or two percent. The narrower the bid/ask spread, the greater the likelihood that you will make a profitable trade. In addition, one should evaluate the cost of commissions when trading. Analyzing these two elements is essential for establishing profitable trades.
While options traders should be completely aware of other factors which help determine whether the trade that they are entering makes sense, understanding costs is a good place to start. In addition, traders must evaluate technical and fundamental factors associated with the underlying instrument before establishing the position and analysis of options valuation. While it may seem like a laundry list, our Options Guide provides a detailed look at the following essential issues: 1) historical and implied volatility, 2) the implied volatility skew, 3) relative value of options, 4) the appropriate options trading strategy given the market or volatility bias and 5) risk management. A combination of analyzing costs and the key options trading factors mentioned above provides an options trader with the best opportunity to make money.
Analyzing costs when initiating a strategy is relatively simple. You can easily determine the difference in the bid/ask spread and you know exactly what your commissions are per contract traded. Unfortunately, when the time comes to liquidate the position, those cost parameters may have changed dramatically. Exercise or assignment costs for in the money options can be dramatically different than the typical expense when initiating the transaction. If I am short a call spread in which both options are in the money, the transactional costs may be much higher than I expected. Be sure that you understand the cost differences. In addition, market liquidity of deep in the money options is typically much wider than those that are out of the money. If your position involves in the money options, you have to expect that liquidating costs are going to be higher.
The table below shows some options prices for the September expiration cycle. The snapshot of prices was taken at the end of the day. Measuring liquidity in the 219 Calls, the difference between the bid/ask spread is less than two percent. Earlier in the day, however, the spread was less than one percent. One final caveat that you may not have considered is that on the final day of trading, as the day goes on, the bid/ask spreads tend to get wider. Waiting until the final hours of trading before expiration can find you in a situation in which, if you are trying to liquidate to avoid exercise or assignment fees, can also be costly. The goal is always to keep controllable costs low so that if you analyze potential trading costs, your bottom line will likely be better. While you have no control over liquidity, by trading at times that options tend to be most liquid, you increase your chances of making money. Evaluating liquidity costs and your trading firms cost structure is essential. If you have any questions: Contact Us.
Options trading involves significant risk and is not suitable for every investor. The information is obtained from sources believed to be reliable, but is in no way guaranteed. Past results are not indicative of future results.