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How You Might Be Losing Money On Your Option Trades

In How Can The Average Guy Succeed Trading Options? I wrote about how there is no minor leagues in options investing… whether you're a raw rookie or a seasoned pro… we are all trading in the same markets.

The great thing about options investing is that it's still a relatively new investment vehicle. Sure, they've been actively traded on the exchange since the 1970s…however, the last 5 years has seen a real jump in interest.

What once seemed like a mystical product is now becoming more mainstream.

Of course, media coverage and advancements in technology have played a major role. Retail investors have access to the same tools as professionals. This includes user-friendly execution platforms, research and analytic tools.

The brokerage industry has recognized this by offering more competitive commission rates for option investors.

With increased investor participation comes more competitive markets. Some stock option spreads are only a penny different from the bid and the ask spread. Not only that, but there are also short term opportunities through the use of weekly options.

Option investing allows you to hedge risk in a stock portfolio…but it also allows you to express investment ideas with less use of capital. Because options are leveraged products they give the investor an opportunity to make an obscene amount of money… sometimes in a short period of time.

With that said, if you're not familiar with how options move and don't have the basics down…you could also lose money very quickly.

That's why I have created a great list of articles for you to review, read & learn.

Now, if you're making the transition from stocks into options or have been using them for a while, I have some important advice to share with you.

At the moment, there is probably only a couple hundred of options that offer competitive bid/ask spreads. That means not everything is really tradable and you should be selective with which stock options you choose.

Here's a likely scenario, you might look at a stock chart and have a bias on direction.

Instead of buying or selling the stock, you can use options to reduce the amount of capital required, which helps reduce your risk exposure and gives time to see the trade work out without the fear of getting stopped out.

However, just because options have their obvious benefits, you still want to put yourself in a position to be profitable if your idea is right.

How do you do this? Well, first what you want to do is open up an options montage. This is just industry jargon for a list of tradable options in a particular stock or index, categorized in expiration periods and option strike price.

In addition, you'll get live quotes, the bid/ask spread, last sale, option greeks, implied volatility, volume and open interest.

In the beginning, you want to focus on the volume and open interest.

Now, volume refers to the amount of option contracts traded that day. Open interest refers to the number of outstanding option contracts that are still open. Each expiration period and strike price have their own volume and open interest statistics.

Ideally you want to get involved with something that either has a decent amount of trading volume that day or open interest. Why? The answer is simple… unneeded transaction costs can kill a great investment idea.

For example, on September 8th 2014, Emergent BioSolutions (NYSE:EBS) was awarded a $29 million contract for development of vaccine formulations effective against NAID priority pathogens.

With Ebola outbreaks happening in several parts of the world, it's become one of the most talked about topics in the media and news today.

Now, let's say that you believed a mini bubble will occur in companies that are linked to the Ebola story, driven by speculators trying to catch the next hot stock.

When we pull up the options montage, you notice that EBS has options and they want to buy calls to express a bullish opinion.

With the stock trading around $22.65 per share, the $22.5 option strike is the closest to the ATM price.The September $22.5 call had zero volume and 10 contracts of open interest.

What's worse is the spread was $0.10 bid and offered for $4.90.

Two things here, you're either the smartest investor who trades options or there is something wrong.

Why? Because no one else has this opinion…not saying that it's impossible that these options couldn't draw more interest…however, no one has yet to share your same view yet.

Moving forward, check out this spread $0.10 bid at $4.90 offered. That shows you that there is very little interest in these options and the option market is not competitive at all.

Most likely you'll have to pay close to the ask price when you enter and when you exit you'll have to sell your contracts close to the bid price. This is also referred to as slippage.

Let's say you trade one contract like this once a week.

Let's say you lose $.15 in premium every trade (being generous with that, it's probably worse) for one year. That's $780 a year you've lost on just that one measly contract.

Now, if there is no recent order to price check, it's hard for you to get a feel of what you should be buying or selling at. One way, is to try to "make the market" yourself.

Let's say you wanted to buy 10 contracts of the September $22.50 calls.

You'd place a bid slightly above the highest bid. In this example, bid $0.15 with one contract. Most likely, the electronic market makers will join you by raising their bid to $0.15.

You could work yourself up until the market makers stop joining you. For example, let's say at $1.50 you are the only bid. The market makers are telling you that they are not willing to pay for it at that price.

By doing this, you'll get a better feel of where the market is. This is much better than guessing and possibly paying too much for options. In any event, these types of option investments should be eliminated if you're new to options.

You've got to put yourself in a position where the probabilities are in your favor. If you're buying options like this, slippage and commission costs will push your break-even farther away and decrease your chances of becoming profitable.

By the way, the market makers are not trying to screw you, they are just trying to make money off the bid/ask spread. Without competition or demand, it's just you and them.

Imagine going to the stadium to watch a professional football game and wanting to grab a beer. Guess what? Beer is expensive because there isn't a lot of competition inside a pro stadium.

That means you have to pay up in order to enjoy a beer at the stadium. However, outside of the stadium, you can go anywhere to buy beer, places like grocery stores, deli's, retail warehouses, beer and liquor stores.

They are all offering the same products and competing for your business. Because of this, prices are much lower than inside an arena or stadium.

Competition in option investing is a good thing.

You've got to take all of this into account when you're trading options. Ask yourself, can this trade make money even with all that slippage?

In most cases, buying call options under these conditions is a losing proposition.

Selling premium probably makes the most sense. By selling premium, you're betting that the underlying doesn't reach a certain price or stays in a range…in certain situations buying premium could be more profitable…however, slippage doesn't destroy your idea and the probabilities of success are greater.

I've heard too many stories from traders about how they got involved with something that wasn't very liquid…the position moving in their favor but they either couldn't get out or the option premium didn't move enough for them to close out of the position for a profit.

What you trade along with the strategy selected is incredibly important.

Earlier I mentioned that you should always look at the volume and open interest. Keep in mind, that certain expiration periods might have more volume and open interest because of a catalyst, like an earnings announcement.

Make sure you're aware when you're stock is announcing earnings. Trading earnings is a completely different animal, to see what I mean just read, "Don't Trade Earnings Before You Read This".

In "What Are The Best Stocks To Trade Weekly Options?", I write about a technique that you can use to check if the bid/ask spread in an option is competitive. In the beginning, you want to focus on options that offer a competitive bid/ask spread.

Again, the major reason here is to avoid slippage costs.

The bid/ask spread changes for a number of reasons. Those changes come from the time decay element of options, movements in the stock price and the changes in option volatility. The first two reasons can be explained easily.

However, option volatility could change because of potential news/catalyst…uncertainty. In addition, supply and demand play a major role on what causes shifts in option volatility.

The more demand for an option, the greater the volatility rises and the more expensive options become.

Think about it, if you are looking to trade an option that no one else really trades…how can you expect the bid/ask spread to be competitive. There is no incentive for the market makers to adjust the spread, they are like the beer vendors inside the stadium.

Avoid Market Orders-All Together

In the EBS example, a market buy order for those September $22.5 calls would have cost $4.90 per contract. That means you'd need the stock price to increase 21% by expiration (less than 2 weeks time) just to break-even on the trade.

With that said, limit orders are your friend. By placing a limit order, you've decided what you're willing to buy or sell an option for. You're not at the mercy of the market maker's prices because you've defined your price.

That doesn't mean you'll get filled at your price but you've defined your terms.

You see, if you're used to trading stocks, liquidity is usually not a big issue. However, with options it's something you'll have to focus on.

With that said, if you really like an idea and liquidity is a possible issue…you'll have to look at alternative strategies like spreads, selling options or using the stock instead to avoid or reduce the role of slippage.

Without a doubt this is one of the most common mistakes new option investors make. Luckily it's an easy issue to fix.

Here's how you can avoid giving your money away foolishly:

1) Put your focus on options that offer great liquidity. By observing the option volume and open interest on an options montage you can quickly identify what is worth trading.
2) You'll want to look at the bid/ask spread and focus only on options that offer competitive markets.
3) You also want to avoid market orders and execute limit orders when you start investing with options. It's tempting to try to get involved in "hot stocks" that move…however, if there is no liquidity in their options…you're likely going to have a tough time making money.

Of course, there is more to selecting the right stock options, stuff like understanding binary events with options, defining risk before entry and identifying if options are relatively cheap or expensive. These topics will be covered in detail in future posts for you.

By the way, have you ever gotten into a stock option and gotten completely chopped up in slippage costs?

If so, I'd like to hear your story. I'll be hanging out in the comments section below.

I almost forgot, if you'd like a more in detailed introduction on how options can be used to create better returns for you…make sure you get a copy of Fearless Income For Leverage.