Anyone who tells you that trading options are as easy it is trading stocks is lying to you. That said, almost everything about options is different from trading stocks. Even the bid vs. ask spread can be confusing if you don’t know what you are searching for.
Getting Ready For Options Trading
Not every stock is optionable and not every stock that is optionable is worth trading. You see, liquidity plays a significant factor in any options trade you place and if you don’t understand this concept, it could end up costing you.
How can you tell which options are worth trading and which ones are worth avoiding?
You look at the volume, open interest, and the bid vs. ask spread.
Volume refers to the number of option contracts that day (bought and sold). These could be opening or closing positions.
Open Interest refers to the number of contracts outstanding (open positions only).
The option chain above shows the volume, open interest, and bid vs. ask spread for a series of Apple (AAPL) options. If you take a look, the call options are situated to the left, the puts to the right, and the strike price down the middle. In this example, Apple is trading at $174.80, making the $175 strike the closet to the at-the-money options. If you look at the left, over 4,209 contracts $175 calls traded. That said, 43,216 contracts are outstanding. The open interest changes the following day, and know that it will be anywhere between 39,007 to 47,425, depending on how many of the 4.2K contracts were opening or closing positions.
- As a trader, you want to focus on trading options that experience strong volume and open interest.
Options Liquidity: Bid vs. Ask
Take a look at a series of options in Stamps.com (STMP). On average the stock trades 500k to 1.5M shares a day, depending if there is a catalyst or not. That said, the stock is optionable. However, if you look at the option chain above, you’ll notice that the options are not very active. The $90 calls only traded ten contracts, and the $95 calls only traded four contracts. Now, for someone like myself, who is comfortable trading hundreds of option contracts per position, STMP options are just not going to cut it for me.
But do you know what else is a dead giveaway that these options aren’t tradeable?
The bid vs. ask spread too wide.
The $95 calls are $4.20 (bid) at $5.00. The spread is $0.80 wide. If you paid the market price on your entry and exit, you’d put yourself at a significant disadvantage because you need to make up $1.60 in slippage. Of course, you can always try to place a limit order.
But your order will only get filled if someone agrees at the same price. Furthermore, if there is a breaking news story in a stock like Stamps.com, you can expect the market makers to make the spreads even wider. They are making it very difficult to trade.
You can also look at the vega of the option to judge how competitive spread is. Vega is the option greek that tells you how much the price of an option will change for every +/- percentage point move in implied volatility. A competitive option spread will be as wide (or less) the vega of that option.
For example, the $95 Call in STMP is $4.20 by $5.00. But the Vega is only $0.11. In other words, these options are a rip-off.
Competitive Option Spreads
By looking at the open interest, volume, and the competitiveness of the bid vs. ask spread, you’ll put yourself in a position to avoid bad trades.
Here are some more examples.
Source: think or swim
Take a look at these options above in Apple, the $175 calls. The spread on the options is $3.85 (bid) vs. $3.95 (ask). The vega on those call options is $0.20. Now, only about 500 contracts traded, but the spread is only $0.10 wide, and the vega is $0.20. In other words, these options are highly competitive and worth trading if you had a view on the stock.
On the left-hand side, you’ll see a series of Tesla (TSLA) calls. The $320 calls are trading $13.70 by $14.00, and the vega for those calls is $0.37. Despite these options having a high dollar price, they are priced well, and the spread is narrower than the vega.
One of the easiest and fastest ways to lose money trading options is to trade options that are illiquid. The best way to tell if an option is tradeable is to look at the volume, open interest, and the bid vs. ask spread.
Now, if you’re ready to learn more about options, make sure to get a copy of my latest eBook, 30 days to options trading, right here.
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