The Importance Of Liquidity, Volatility, And Sector When Using The Daily Options Trading Strategy

by: Kevin M. O'Brien

I am often asked why certain stocks are not included in my daily options trading strategy that would seem like obvious choices. Among the stocks most frequently asked about are Mastercard (NYSE:MA), Panera CME Group (NASDAQ:CME), Chevron (NYSE:CVX), McDonald's (NYSE:MCD), and Apache (NYSE:APA).

In this article, I would like to explain why it is not as simple as picking any stock to use with the strategy and outline some details of the reasons why for each.

Before going any further, I recommend that you read my previous articles on my daily options trading strategy at the following link on Seeking Alpha if you have not already done so:

Daily Options Trading Strategy article.

I like to start every article with the basics on how to use this strategy with the five technical indicators. Here is a quick summary and recap:

  • Bollinger Bands - I use the 12,2,2 as my parameters, i.e. 12) as the Simple Moving Average ((NYSE:SMA)) and Standard Deviation, 2) as the standard deviation of the top band, and 2) as the standard deviation of the bottom band. As a personal preference, I will not begin to even consider making a trade until I see the current price action move below the bottom band (calls) or above the top band (puts), but this is only one of the indicators needed out of five total.
  • Relative Strength Index - I use a length of 12. The RSI is an indicator that shows when a stock is at overbought and oversold levels. It has a range of 0-100. A reading on the RSI of 70 indicates overbought levels, while 30 is considered oversold. Some traders like to go even below the standard 30 level for a buy confirmation, but it is ultimately the trader's choice.
  • Intraday Momentum Index - The IMI is invaluable as far as I'm concerned for an options trader who gets in-and-out of positions quickly. The Intraday Momentum Index is similar to reading the Relative Strength Index, in that both of them have a range of 0-100. Again, 70 indicates overbought, while 30 is considered oversold. I also use the range of 12 to correlate with the RSI. Again, it is the trader's preference as to what length works and what he or she likes to use. The Intraday Momentum Index is a very powerful technical indicator to use for any type of trader.
  • Money Flow Index - The MFI follows the IMI as the next indicator. The MFI is a momentum indicator that is used to determine the conviction in a current trend by analyzing the price and volume of a given security. The MFI is used as a measure of the strength of money going in and out of a security and can be used to predict a trend reversal. The MFI is range-bound between 0 and 100 (like the RSI and IMI) and is interpreted in a similar fashion as the RSI and IMI. The fundamental difference is that the MFI also accounts for volume, whereas the RSI only incorporates price. It is also different in the fact that instead of the number 30 indicating oversold levels, the Money Flow Index uses 20 as oversold and 80 as Overbought.
  • Full Stochastic Oscillator (do not use only the Fast or Slow Stochastic) - Used by many Forex traders, I find the FSO tremendously helpful in my trades as another indicator that confirms what the previous four have already done. Combining all of these indicators together really validates when it is an opportune time to buy. The FSO is a combination of the Slow Stochastic and the Fast Stochastic and is more advanced and more flexible than the Fast and Slow Stochastic and can even be used to generate them. Readings above 80 act as an overbought signal while readings below 20 act an oversold signal. The parameters I prefer to use are (10,6,6) for daily trading.

To keep up-to-date with the current stocks I am using with this strategy, they are the following:

Among the other stocks I use as alternates are the following:

Mastercard Incorporated is actually a great stock that sees very wide price ranges daily, which is ideal for this strategy. The main issue that I have using it is the very wide bid/ask spread and the lack of liquidity with the options.

For example, when you use this strategy you want to purchase in-the-money or deep-in-the-money options that are one month away from expiration. I will always check the open interest of a particular strike price. With Mastercard trading at $396.00/share, a call option would need to be bought using a March 2012 $380.00 strike price. The current open interest for this strike price is 414. That is not a high number.

It is even worse if you were to buy put options with Mastercard. With the stock trading at $396.00/share, an ideal strike price would be the March 2012 $405.00 put options. The open interest here is currently at 87.

Even more concerning is the bid/ask price, which has a $0.50 differential. This will present problems getting into the trade, but an even bigger problem will be when you need to exit the trade. You want to get an optimal price when buying and selling. Since this strategy only requires a $0.60 - $1.00 sell limit above what was paid for the options, a $0.50 difference in the bid/ask price becomes a major issue. Chances are that you will have to sell it for far less that what the ask price is going for.

CME Group is another stock that can work extremely well using this strategy. As an example, CME Group has a $12.00 swing from low to high for Friday alone. This happens frequently with this stock.

Yet, there is extreme risk buying option contracts on CME Group because of the very wide bid/ask spread. When using in-the-money contracts or DITM contracts, there is usually over a $1.00 separation on the bid/ask spread. I do not want any part of that. Option volume and open interest is stable, if not great., but it is the bid/ask spread that keeps me away from using CME Group with my strategy.

McDonald's is a stock that is near $100.00 share and option volume is not a concern, but the stock is not volatile in the least. More often than not, you will be holding any trade using McDonald's for far too long. Remember, the goal of this strategy is to be able to exit as soon as possible. McDonald's does not provide that.

I generally like to steer clear of any stocks that are reliant on oil prices or banking. This would include Chevron, Apache, and Goldman Sachs.

Certainty, not uncertainty, is what we want when using this strategy. I do not want to be in an options position that has a high probability of a "news" event or release that may effect how a stock trades. To use an example, OPEC could announce at anytime that there will be a cutback or increase in production regarding oil. Both Chevron and Apache's stock would clearly be influenced by something like this, so I want no part of that.

Every week I will use my stock screener to find any new potential candidates to add to my strategy. FinViz has a great one at this link or my broker screener, OptionsXpress.

Before adding any stock to this strategy, you really need to test it out and see if it could possibly work. The truth of the matter is that there just are not too many stocks that are over $100.00/share that fit all of the criteria mentioned in my previous articles.

As time goes along, there will always be some new additions and removals, so please check my InstaBlog for those updates.

If you ever have any questions on my daily options trading strategy, please leave a comment or e-mail me. I usually respond very quickly.

I have also written an e-book on this strategy. It is available on the Amazon Kindle or you can download the e-reader to your desktop/laptop. If you do not own a Kindle, you can download the App to your PC.

Thanks again.

Disclosure: I am long AAPL, GOOG, APA, WYNN, CF.