The Foundation Of Options Trading

 |  Includes: DIA, FAS, IWM, QQQ, SPY
by: Andrew Crowder

Before I get to some market info, I want to go over a few options trading basics.

The first, and most important, step in options trading is to create a watchlist of highly liquid, optionable stocks or ETFs. This will be the foundation of your all your trading endeavors. The reason you MUST only use highly-liquid stocks or ETFs is so that you can rely on pricing efficiency.

The more liquid the option, the tighter the bid/ask spread. This is extremely important because the bid/ask spread impacts the cost of using options. Wide bid/ask spreads eat into the potential profitability of your investment, and contribute to what is known as "slippage."

The easiest way to search for what I call "tradeable" options on ETFs or stocks -- Volume. I look for ETFs with an average volume over 1 million shares traded because I want liquid options. Sometimes the 1 million may not be enough, but it is certainly a good starting point. Again, liquidity directly translates into a reasonable bid/ask spread for options -- this is critical. It allows you to trade in and out without giving up much of an edge. But again, it all comes down to a tight bid/ask spread. Without it, your underlying is pretty much useless for trading options.

Sometimes I receive emails asking me to look at a small-cap or penny stock with 50,000 shares traded. For one, most, if any, offer options. Remember, I use a probability-driven approach using various credit spreads for my strategies. This would be impossible to do with illiquid underlyings.

Lack of volume is one of the main reasons that I do not use individual stocks in my strategies. Most stocks do not offer liquid options. And the ones that do are subject to volatile moves due to unforeseen announcements, earnings surprises, etc. There is no need to take on this type of risk knowing that I can make consistent gains using highly liquid ETF options.

Also, by limiting the number of underlying stocks or ETFs, you have the ability to focus on and become familiar with a select group that will aid in making your trade assumptions. Creating this watchlist will save you lots of time. You'll thank me later.

For my strategies, I follow and provide roughly 40 highly liquid ETFs that include SPY, IWM, DIA, QQQ... some of the most liquid options in the marketplace.

Best of all, I provide them here on a daily basis.

Market Mumbo Jumbo

Just a few random thoughts.

Wow!!! This rally has surprised almost everyone. Okay, let me rephrase... every professional trader I have spoken with today. Have you taken a look at the financials lately? FAS was trading for roughly $111.50 last Friday, now the leveraged ETF is above $121.50. 'Same goes for all of the major benchmarks. But, as we all know… all good things must come to an end (if you are a bull), and now it's the bears' turn. I expected to see a push lower towards the beginning of the week, but now it looks like it's going to occur over the next few days. While there are no guarantees in trading (we all know that, right?), the pot odds are leaning heavily towards the bearish camp. Almost every ETF I follow has pushed into an extreme state, so the recent rally looks extended at this point. Remember, expiration is Friday and SPY has dividends out Friday, so if you have any in-the-money positions, be aware.

Disclosure: I am short IWM, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.