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We realize that options do not trade at just one priceGETTING FILLED Now that youve been introduced to spread trading, there are a few mechanical realities that must be dealt withnamely, getting your spread order filled at a price you can live with. There are many factors involved between the time you hit the send button and the time you receive confirmation that your spread has been filled. Before you hit send, make sure you assess the bid/ask price of the spread. The bid is the highest price a prospective buyer (trader or dealer) is prepared to pay for a specified time for a trading unit of a specified security. Thus, the bid is also the price at which an investor can sell to a broker-dealer. The ask is the lowest price acceptable to a prospective seller (trader or dealer) of the same security. The ask, therefore, is the price at which an investor can buy from a broker-dealer. Together, the bid and ask prices constitute a quotation or quote and the difference between the two prices is the bid-ask spread. Sometimes you may have a hard time cutting the bid/ask on a spread, and even miss getting filled at or above the asking price. What Im talking about is a common occurrence that goes something like this: You like stock XYZ, which is trading at 110. You decide youd like to go four months out on the 100/120 bull call spread. The bid on the spread is 5.50 and the ask is 6.50. In other words, if you owned the spread, it would have a selling value of 5.50. If you were buying the spread it would have an asking price of 6.50. Not wanting to pay what the market is asking, you put in a limit order of 6 on the buy side, meaning that youll pay up to $600 for the spread. As the day wears on, you check your account online and see you havent been filled. The stock dips some, and you check the bid/ask on the spread again; its now 5.75 bid, 6.75 ask. Still you havent been filled, and youre feeling frustrated! Whats going on? Heres the explanation: In order to complete a spread as a single transaction, the traders on the floor must find market makers to match up both sides of the spread in a single transaction. There has to be someone willing to sell a 100 call while someone else buys a 120 call. This is a much more difficult task than simply selling or buying calls as individual transactions. So, even though you may only be trying to cut the bid/ask by a small amount, it can be difficult to get a market maker to take this as a combination order. This is especially true in fast moving markets where scores are being reeled off in hundreds of individual contracts. Now the trader who has your ticket has the market maker stop, calculate the net amounts, and then make a decision. I had an interesting and frustrating event a few months back that will shed some light on this topic. I wanted the August YHOO 55/65 bull call spread at 5.50. The bid/ask was approximately 5 and 6, so I was trying to shave a small amount, half a point. Hours went by and I checked again. YHOO had dipped intraday as I expected, and I was looking for my fill confirmation. The ask was now 5.75 and I still didnt have my order filled! I had the head of my brokerage office call down to the floor and I learned that in a fast moving market (as it was) no one wants to stop to calculate a spread when individual calls and puts are flying back and forth in lots of 20, 50, or 100 contracts on a stock like YHOO. I could have legged in, but I have a rule that I trade a vertical spread only as a limit order on the cost of the overall spreadno legging in. So I missed the trade. However, sometimes this situation can work to your advantage. Lets say you offer 8.50 on a spread that was bid/ask at 7.50 and 9.50. Then the underlying stock, XYZ, starts to fall; the ask on the spread had fallen to 7.75. You decide to cancel and try the trade again when its on the way up. You hold your breath, hoping you didnt already get filled as the asking price passed down through your offer of 8.50. Sure enough, you get your cancel confirmation in a little while and breathe a sigh of relief. Sure, XYZ will likely come back, but it would be better to place the bull call spread buy on the way up than on the way downunless youre specifically targeting a certain price. One more piece of advice: Dont chase the market. I sometimes wish I had raised my offer on YHOO; but I won on that transaction anyway because I stuck to my principles. Besides, the money I would have put in YHOO is working for me in another trade. If you wish to leg in (buying the lower call, then selling the higher call), be sure youve solidly confirmed the market direction first. BID-ASK SPREAD: A CLOSER LOOK From the first moment we are exposed to a real options quote, we realize that options do not trade at just one price. There is a bid price and an ask (or offer) price. For example, the Cisco (CSCO) October 20 calls do not trade for 55 cents. Instead, you may see a quote similar to this: CSCO 22.50 Calls: .50-.60. In this example of the CSCO 22.50 calls, $.50 is the bid and $.60 is the ask (or offer). That means that everyone who is interested in selling CSCO 22.50 calls can do so at $.50 and all interested buyers of CSCO 22.50 calls can own them for $.60. Since we are not market makers, in order to guarantee ourselves a fill, we must pay the ask and sell the bid. To illustrate the meaning of these two prices, imagine walking into a car dealership. A dealer has two prices on a car. There is a dealer invoice and a sticker price. A car dealer is willing to buy cars for dealer invoice, and is happy when theyre sold at sticker price. Unless the dealer is trying to pad the sales numbers to meet some quota, we will not be lucky enough to drive a car off a lot for dealer invoice. However, in buying cars as well as in trading options, we try our best not to pay sticker price. Of course, this means the dealer can refuse to sell us the car, just as a market maker can refuse to trade with us. Only by paying the full no-haggle price can we be assured a fill on a trade. In trading options, the reality is that while the quoted best ask in CSCO 22.50 calls may read $.60, someone in the CSCO pit may be willing to sell those calls for less. A car dealer may be willing to sell you a car for less than sticker price, but why pass on the chance that you or someone else might pay full fare? So the ask price will remain $.60 until someone tests itnamely with a limit order between the two amounts that define the bid/ask spread. A limit order is an order to buy or sell a financial instrument (stock, option, etc.) at or below a specified price. For instance, you could tell a broker to Buy me one January XYZ call at $8 or less or Sell 100 shares of XYZ at $20 or better. I bring up the example of CSCO because of the incredible liquidity in that stock. That liquidity in the stock and in its corresponding options allows the bid-ask spread to be very tight10 cents wide, in this case. So the question then arises: Is there anything that keeps the market makers from creating wider spreads? In the case of less liquid stocks, is there a chance that spreads can become too wide? Is there anything to protect us from abusively wide spreads? Actually, there is! It may not seem like it at times, but there exist legal width limits for options. This practice was instituted by the exchanges to keep the market makers in check and to entice retail customers to trade more. These limits are based on the option pricethe higher the price of the option, the higher the allowable width of the bid-ask spread. The limits are shown in Table 5.2. One small note: For option prices $3 and up, options no longer trade in nickels. The smallest denomination for those options is dimes. So do not try to pay $3.65 for an option. We must make up our mind to make our purchase price either $3.60 or $3.70. A pet peeve of many market makers is a retail customer who does not know this information. Now lets look at a practical application of legal widths and how they can affect us. Let us revisit those same CSCO October 22.50 calls with a bid-ask of .50-.60. If we decide to be aggressive and pay the ask, we are incurring 10 cents of slippage (the difference between the bid price and the ask price). Now lets say we were right and CSCO shoots up $5; our calls are now worth somewhere around $5.50! As we look to exit our trade, we may look forward to a market quote of 5.40-5.60. However, the limit on the width of those options is 50 cents. Hence the real quote facing us may be closer to 5.20-5.70. Fifty cents of slippage is quite possible. We may console ourselves with the fact that we made some money in our trade, but thats no excuse for giving up so much on our exit. We can usually diminish the problem by testing the market and placing limit orders inside of the bid-ask spread. STRATEGY ROAD MAPS For your convenience, the following subsections provide step-by-step analyses of the vertical spreads discussed in this chapter. Bull Call Spread Road Map In order to place a bull call spread, the following guidelines should be observed: 1. Look for a bullish market where you anticipate a modest increase in the price of the underlying stock. 2. Check to see if this stock has options available. 3. Review call options premiums per expiration dates and strike prices. Bull call spreads are best placed on stocks that have at least 60 days until expiration. The utilization of LEAPS options is a goodchoice for this strategy. LEAPS give you the opportunity to put timeon your side.4.Investigate implied volatility values to see if the options are over-priced or undervalued.5.Explore past price trends and liquidity by reviewing price and volumecharts over the past year. 6. Choose a lower strike call to buy and a higher strike call to sell. Both options must have the same expiration date. In general, a good combination is relatively low buy strikes combined with higher sell strikes. Get the breakeven low enough so that you can sleep at night. The lower buy strikes lower the breakeven point. Give yourself plenty of room to profit if the stock runs. This is accomplished by choosing higher sell strikes. 7. Determine the specific trade you want to place by calculating: Limited Risk: The most that can be lost is the net debit of the two options. Unlimited Reward: Calculated by subtracting the net debit from the difference in strike prices times 100. Breakeven: Calculated by adding the lower strike price to the net debit. Return on Investment: Reward/risk ratio. 8. Create a risk profile for the trade to graphically determine the trades feasibility. The risk profile for a bull call spread visually reveals the strategys limited risk and profit parameters. Notice how the maximum profit occurs at the short call strike price. 9. Write down the trade in your traders journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade. 10. Create an exit strategy before you place the trade. Consider doing two contracts at once. Try to exit half the trade when the value of the trade has doubled or when enough profit exists to cover the cost of the double contracts. Then the other trade will be virtually a free trade and you can take more of a risk, allowing it to accumulate a bigger profit. If you have only one contract, exit the remainder of the trade when it is worth 80 percent of the maximum possible value of the spread. The reason for this rule is that it usually takes a very long time to see the last 20 percent of value in a profitable vertical spread. Its better to take the trade off and look for new trades where the money can be put to better use. We recommend exiting the trade prior to 30 days before expiration. 11. Contact your broker to buy and sell the chosen call options. Place the trade as a limit order so that you limit the net debit of the trade. 12. Watch the market closely as it fluctuates. The profit on this strategy is limiteda loss occurs if the underlying stock closes below the breakeven point. The underlying stock rises above the short strike: The short call is assigned and you are obligated to deliver 100 shares (per call) to the option holder at the short strike price. Exercise the long call to buy the underlying stock at the lower strike and deliver these shares to the option holder. The resulting profit is the maximum profit available. The underlying stock rises above the breakeven, but not as high as the short strike: Sell a call with the long call strike and buy a call with the short strike. There should be a small profit remaining. The underlying stock remains below the breakeven, but above the long strike: Offset the options by selling a call with the long strike and buying a call with the short strike to partially mitigate the initial debit or allow you to pocket a small profit; or wait until expiration and sell the long call to offset the trades net debit and let the short option expire worthless. The underlying stock falls below the long option: Let the op tions expire worthless, or sell the long call prior to expiration to mitigate some of the loss. |
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