Finding Options Contracts worth trading can be quite difficult. It is essential for long-term trading success to enter positions in transparent markets with ease of execution and good value. Therefore, Liquidity is an important element of evaluating whether trading a particular instrument is worthwhile. My top five Instruments that provide a significant opportunity to meet the needs of transparency and liquidity are SPY (SPDR S&P 500 ETF Trust), AAPL (Apple Inc.), GLD (SPDR Gold Trust ETF), FB (Facebook, Inc.) and IWM (iShares Trust - Russell 2000 Index Fund).
These markets are chosen because the Liquidity Percentage of out-of-the money options, in the first several Strike Prices out-of-the money, is excellent. To determine the Liquidity Percentage all you have to do is Subtract the Bid Price from the Ask Price and calculate that difference as a percentage of the Ask Price. The calculation is easy, but essential in determining if a particular Product’s Options are worth trading. If the Liquidity Percentage is between ½ percent and a maximum of 2% on a nearby out-of-the money Option, which it should be in the above mentioned instruments, then the Liquidity Test has been met. The Table below (from just before the 4:00 PM Close on Tuesday) shows the July Options Series. While the June Option Series may have even better Liquidity on certain Strike Prices, the cheaper the Option, the more difficult it is to pass the Liquidity test.
The second factor which makes particularly SPY and IWM so desirable to trade is the Implied Volatility Skew. The Skew in both markets is significant to the Put side meaning that each farther out-of-the money Option has a larger Implied Volatility. The steeper the Skew the more opportunities there are to create interesting Options Trading Strategies. Three strategies that stand out are: one by two Put Spreads, Call Fences and Short Options Pairs (Selling Call Spreads and Buying Put Spreads). SPY and IWM provide an excellent environment to initiate these trades. The Table provides a sampling of the Implied Volatility Skew for a limited number of Strike Prices.
While Apple and Facebook both provide excellent liquidity and have an Implied Volatility Skew which resembles that of the Stock Indices, the Skew is not as prominent and therefore does not provide as much value when initiating positions. The positive factor is that if you are a speculator or a hedger, Apple and Facebook provide an environment for trading in which you are not forced to give up too much of an edge to participate. The Strategies mentioned in the previous paragraph may be interesting depending on how far out in the calendar you are willing to trade.
For those interested in trading the metals, specifically Gold, GLD (SPDR Gold Trust ETF) provides excellent liquidity and the market tracks the price of Gold Futures very effectively. Unlike some other products that attempt to mimic metals like Gold and Silver, GLD is an excellent product for Trading Options on Gold. The Implied Volatility Skew is the inverse of Stock Indices with the out-of-the money Calls having a higher Implied Volatility than most of the Puts. Our Webinar Preview PDF provides additional information about Implied Volatility, The Skew and Options Trading Strategies.
The article is only a primer as to what to look for when picking a contract to trade. Unfortunately, high levels of liquidity do not exist in that many Options Contracts. Staying away from illiquid markets should make a substantial difference in your trading success. Our Options Training Webinars provide an environment for one on one webinar training sessions to improve your trading technique. If you’re not evaluating Liquidity, Historical and Implied Volatility, the Skew and the best Strategies to go along with that analysis, 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.