With millions of Options Contracts trading across product lines, it is easy to find the lure in trading them. Due to the number of participants, the competition can be fierce. It’s not easy for an individual trader to execute efficiently against algorithms. There are, however, things to look at and assumptions to be made before a trade should be executed which will improve your likelihood of making money.
The first essential detail to watch is the liquidity of the product that you are trading. If markets are wide then the market-makers/algorithms will know exactly when to pick off your order and thereby you will have executed your end of the trade at the worst price possible. If you are trading liquid markets like those in SPY (SPDR S&P 500 Trust ETF), GLD (SPDR Gold Trust), AAPL (Apple, Inc.) and QQQ (NASDAQ 100 Powershares) the cost of trading is vastly reduced. To evaluate liquidity, simply take the difference between the Bid and Ask Prices of out-of-the money options and take that value as a percentage of the Ask Price. The lower the percentage, the better it is to trade in that market. Use SPY as your guide.
The second thing you might consider is that just because you can trade in the middle of the Bid/Ask Spread, it may not be the best price. Consider the following example with Bids and Offers, the mid-point for trading and the Strike Prices.
In the example, if you look at the prices of the Bid and Ask and calculate the mid-point you might think you were getting a fair value if you could trade any of the Trade Prices shown above. Unfortunately, the price of the 95 Put is a bad deal. The easiest way to determine that is the spread prices. In the example, the 105/100 Put Spread is priced at .40. The 100/95 Put Spread is priced at .20 and the 95/90 Put Spread is priced at .25. The lower the Put Spread the less it should be worth. Therefore, the 95 Put is too expensive and is the best Option to sell if you can trade the mid-point in all of the Strike Prices. If you bought the 100/95 Put Spread and sold the 95/90 Put Spread you would own the butterfly for a credit. This is my kind of trading and a good way to look for valuation. Contact Us if you believe this kind of analysis is helpful.
For the third thing, if you are planning on scalping options, in addition to considering the liquidity of the option, consider the Delta of the option you are going to trade. If the width of the market you are trading is wide and the Delta is low, it may take a fairly significant move in the underlying contract just to break even. If you are planning on holding your option for a significant move, then this issue is not as important but for those scalping options, it is essential analysis.
The fourth factor to consider with any long-term options trade is the Implied Volatility Skew. The Skew provides the opportunity to create an options trading strategy which will meet your risk/reward requirements. If you have a significant market bias, using the Skew enables you to get long or short the underlying by building a strategy which has an edge. The perfect example is the E-mini S&P Futures. It has a significant Skew to the put side with the farther the out-of-the money puts having a greater Implied Volatility. Therefore, you are able, if you are bullish, to purchase out-of-the money calls at a significant discount to out-of-the money puts equidistant from the current trading price. While the position has unlimited risk, it provides the opportunity to get long with a bonus. After the significant move down with Brexit, it was the perfect strategy. You just had to have the desire to get long and the willingness to take the risk of being short the out-of-the money put.
For the fifth recommendation is a quick discussion of risk management. While it is much easier to manage risk with a long options positions and limited risk spread positions by designating a set amount of risk capital to any one idea or idea group, when selling options, risk management becomes much more difficult. It is essential to remain disciplined. Try to have pre-determined exit points. Traders must be willing to take losses or at some point selling naked options can be disastrous.
These are a few essential factors to look out for when trading options. Our Options Syllabus PDF provides an outline of a multitude of skill sets that should be understood when trading options. If you’re trading with the algorithms and don’t have a specific plan or a keen understanding of valuation, there’s an opportunity to improve your skills. Our Individual Option Training Webinars can make a difference in your results. 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.