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Options: Tips, Tricks & Advice
Page Summary:
This page looks at some useful Option tips such as how to handle the expiry, the importance of liquidity, and what strike prices to use.
Options and the expiry date
Most options are never exercised, even if they are in-the-money just before expiration.

If a trader owns the BT Mar £1.50 calls and the stock is trading at £1.75 on or near the expiry date he has 2 options -

  1. Take delivery of 1,000 shares at £1.50, or
  2. Take the easier route and sell the option to realise the profit

Apart from some minor charges the profits would be similar for either of the above.

But some traders do want to take delivery of stock (if long calls or short puts), or deliver stock (if short calls or long puts) on or before the expiry day.

If so they'd instruct their broker to exercise the options, or if the options are in-the-money on the expiry date (normally always the 3rd Friday of the month) they would be automatically exercised by the Exchange.

If you want to exercise an option you obviously need enough money in your trading account. Although the delivery process might seem complicated it's not. Just let your broker's back office handle all the necessary paperwork.

Physical options versus cash settled
  • Question - can you physically deliver Vodafone shares?
  • Answer - yes, because the shares are a physical entity

But how can you deliver the FTSE 100 index? You can't buy it like you can Vodafone so FTSE options, as most indexes, are cash settled.

For example, if you're long 1 FTSE 4,025 call and on the expiry date the index is at 4,125 you'd be paid 100 points in cash or £1,000 (a point in the FTSE options is worth £10).

It's not always true but more often than not if there's a physical entity behind an option, such as shares, they're physically delivered. Options on indexes and other non-physical entities are cash settled.

The importance of liquidity when dealing options
When trading any financial instrument, liquidity is critical. Liquidity = volume.

You want to conduct your business in markets with good volumes and tight bid/offer spreads. A lack of liquidity means that you'll struggle to get a fair price when you enter a trade and almost certainly won't get one if you need to dump it in a hurry.

It's a subtle point with trading and investing but many new to the game miss it completely -

The cost of doing business is often critical to the success of any trading plan

Far too many people think that making good returns is all about buying and selling at the right price, and of course that helps. But costs also play a significant role.

However, it does depend somewhat how frequently you trade. For example, both cheap commissions and tight bid-offer spreads are critical to a day-trader. In fact, many short term traders don't last, not because their trading decisions are bad, rather the cost of doing business eats into their revenues with a vengeance.

But if you're a long term trader, perhaps doing no more than a few trades per month, then commissions and other expenses don't matter nearly as much. However, it is always a good idea to save money if you can.

How to investigate option liquidity (UK Stock options)
Look for two important figures -

1. Obviously the daily volumes and average daily volumes

  • Look at this number on its own and in relation to the size of the company
  • For example, ABC Industries has a market capitalisation of £3.5billion yet there are less than 50 options traded on its stock every day
  • This means no liquidity in the options and personally I wouldn't go anywhere near them - the bid-offer spreads will be too wide

2. How much open interest is there -

For UK stocks I would want to see at least 10,000 open option contracts - Wikipedia link on Open Interest

The table below highlights the above 2 points.

Daily Volume and Total Open Interest on a range of Options

Company
Call volume
Put volume
Total volume
Open Interest
3i Group
4
9
13
2,737
Aviva
207
178
385
31,575
Barclays
2,052
513
2,565
329,785
Glaxo
87
37
124
84,357
Johnson Matthey
0
3
3
33
  • Both the volume and open interest for 3i Group and Johnson Matthey are pathetically low - expect wide spreads
  • The daily volume for Barclays is good with a load of open interest
  • But the daily volumes for both Aviva and Glaxo are not so good. Still, there's plenty of open interest so I would have no problem trading these options
Summary
  • It's hard to make money in options when the bid-offer spreads are wide, the costs maybe 5% or 10%, ie 45 bid - 50 offered
  • Look at the daily volume and open interest to gauge whether the options are worth trading

A lack of two-way business, especially with options, means you'll be trading against the market makers and they're no fools - they'll take points off you all day and every day.

How to work the bid-offer spread

The cost of doing business in the markets is made up of both commissions and the bid-offer spread. With options, commissions are usually of little concern, it's usually the bid-offer spread where costs can go through the roof.

Option market makers generally quote wide prices because they follow far too many different options to be able to update their prices all the time. But they will normally quote a tighter price if a trader starts to quote against them. For example -

  • You're interested in buying an option that is quoted at 70 bid - 80 offered
  • Of course you can get a guaranteed fill if you pay the offer price of 80 but why not use some intelligence and play the game as it's supposed to be played
  • Make the assumption that you won't be able to buy below the mid price of 75 but go 74 bid anyway for a few minutes to see what happens - the market will now be 74-80
  • If nobody has bitten your 74 bid go 75 bid for a few minutes and then go 76 bid etc
  • Chances are you'll get the option for 76, 77 or 78
Don't be worried about entering small orders of 1 or 2 lots (an option contract is often called a lot). In the above example, the market might have started out at 70 bid for 50 lots and 80 offers for 50 lots. So what if you bid 74 for just the 1 lot? It's your money at risk so don't be perturbed by dealing in small sizes.
When To Hit the Bid or Offer

There are times when it's not a good idea to get too clever, ie trying to finesse an order to save 1 point.

When prices get volatile and prices are jumping all over the place, it's often more important to get your orders filled rather than get the best price possible. By holding out for a better price you run the risk of missing the trade completely.

So as a rule of thumb, always strive to get the best price in normal markets but when volatile you should deal at the market. This of course assumes the quote you're being offered is not outrageous.

Summary
  • Learn to work your orders in the options market
  • This is easy to do if your broker provides good online software
  • Saving 0.5 point here and 1 point there is never a lot of money but save 1 point on average per trade and at the end of the year the money saved can be substantial

Remember, costs often play far more of a vital role in generating profits than many people first think - it's not all about buying/selling at the right price.

What Option strikes and months to use
An area in which many people struggle is which option strike to use.

If a share is at £2.00 and you're bullish, which call is the right one to buy? Perhaps the choice is £2.00 - £2.20 - £2.40 - £2.60 etc? Unfortunately there is never a one size fits all answer.

So ask yourself some of these questions -

  • Where do you think the share price is going and over what time period?
  • What the volume and open interest is on the individual option strikes?
  • What does the daily chart look like, is the market trending, is it in a range etc?
  • How bullish/bearish are you? The more so the further out-of-the-money to look for and vice versa

However, as liquidity on many UK stock options is not that good it's often a case of not what you want, rather what the market offers.

For example, if the share in question is £2.00 you might want to trade the £2.60 or £2.80 calls. But when you check the volume and open interest both these options hardly trade whereas the £2.20 and £2.40 calls have plenty of open interest - that is of course where the business should be done.

What Option Months to Use
To figure out which option months to trade I would use a similar type analysis as above. But the main decider will be the volume/open interest.
  • For example, the month might be presently January and there are options for March - June - September and December
  • But when you look at the volume/open interest there's little in both September or December
  • The only tradable months therefore are the first two.
Use software to play around with the strikes and months

We live in a computer generation so it makes sense to use them for options analysis, especially when trying to work out which strikes and/or months to use.

Personally, I feel that if you are not using a computer to analyse the option markets and research your potential trades you're doing yourself a disservice. Maybe you'll leave profits on the table or leave yourself open to the potential of unnecessary losses.

I therefore use Hoadley Options (see FAQ section - What is Hoadley Options) to analyse the different strikes and months to potentially use. Look at this example on the FTSE 100 options -

  • It's Easter and you're mildly bearish on the FTSE index over the next few months
  • The near months available are April, May, June and July
  • The FTSE 100 is trading at around 4,000 and you're looking at put option strikes between 3,925 and 3,725
Enter the prices into your software and start to play around with them - I call this what/if analysis -
  • What would the potential P&L look like if the FTSE 100 dropped to 3,700 and you bought either the 3925, 3875, 3825 and 3775 puts?
  • What would the potential P&L look like if the market rallied sharply and volatility dropped 4%?
  • What would the potential P&L look like if the market traded sideways for the next 3 weeks before starting to gently slide etc

Use the above analysis on all the relevant strikes and different months and you'll often get some new insights to the trade or perhaps spot some other strategy to use.

These types of calculations don't have to be complex and should be done quickly. When you've done enough of them you'll be able to spot intuitively the right type of trade for your market view, or at least be able to spot the trades that don't offer any value or are too high risk.

How to negate some of the timing problems when buying options

Timing is the bane of all options buyers.

I have indicated before the option buyer has to be right on both direction and timing. And even if his timing is out by 1 week or even 1 day that can be the difference between monster profits and a 100% loss.

There's actually a paradox in buying options -

  • On the one hand it's seen as relatively low risk because you cannot lose more than the cost of the option
  • But it's also high risk because the chance of making money are slim

OK, the above won't be applicable for every option's trade I admit but if you continually buy options throughout the year it's going to be tough to show a profit unless you caught some spectacular move such as a stockmarket crash.

Many people involved in the financial markets will tell you that getting the direction right of a market (longer term) is not so hard. But it's the timing where we often fall down.

Getting the timing wrong is not so much of a problem if you've bought a share but it's usually results in losses when buying options because they're wasting assets.

The best way to handle a lack of timing is to first assume that it's going to be off. Then buy options with later expiration dates. For example -

  • The month is now January and you feel by April at the latest the stockmarket will fall by at least 20%
  • Instead of buying the March, April or even May options it's probably better to buy the June, or maybe even the July or August ones (perhaps mix them up, buy all 3 months)
Yes, the longer dated options will cost more money but the chance of success are notably higher.
Summary
  • The paradox of buying cheap (short dated) versus more expensive options (longer dated) is an interesting point to consider for those new to options
  • Risk is not just about the potential of losing a fixed amount of money, it's also about the potential of a trade winning versus losing

The overall risk therefore of buying short dated (under 4 weeks till expiry) cheap options is therefore higher than the risk of buying an option with 3+ months till expiry even though the actual amount of money lost on the first trade will be notably smaller if your timing is out.

Important - use a specialised Options broker
With the advent of the internet most traditional style stockbrokers have turned into online-brokers. I don't know the actual percentage but I'd think at least 75% of all retail orders are entered online rather than the telephone. And probably 90% of all options trades get placed via the net.

But whereas the majority don't need to speak to a broker when buying £2,000 worth of Tesco or BP shares, options are more complex and sometimes an experienced options broker can be of help.

Of course, there will be a financial trade-off. Dealing via the internet is usually cheap because the process is extremely efficient and humans are not involved. But use a broker and the commissions might be double or even triple.

You'll have to work out whether these higher commissions are a worthwhile investment for your options trading. For example, if you need some complex orders worked, are looking for trade ideas or just like to gossip about the markets, then a broker might make sense.

But if you're comfortable dealing off the screen go with an internet broker. Personally this is how I operate using the online broker www.interactivebrokers.co.uk

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  • For my personal trading I like to use Core Spread
  • Got to love their ultra low bid-offer spreads





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