Selecting the Right Stock for Better Trades

In the last newsletter we covered part two of a three part series on how to select the right stock option. We covered, in detail, items 1 - 4 below. We will now complete item 5 and expand this newsletter into a SIX PART SERIES instead of THREE.

There are a number of things to consider when you place an option trade:

1. Option Month - what month should your option expire
2. Strike Price - what is the best choice
3. Delta - what delta should you consider
4. Time Value - how much time value should you pay
5. Bid & Ask - How much should the spread be
6. Open Interest - is open interest important, what is the requirement
7. Money Management - how much to put in one trade
8. Graceful Exits - if the trade does not go the way you hoped

BID & ASK

It is very important to understand how the bid x ask spread works, and the impact it will have on the profitability of your trades. Once understood, placing an order becomes a simple process. Let's face it, market makers are business owners and they are trying to operate their business at a profit! The expenses market makers incur are HUGE so they constantly look to make as much profit as possible with the bid x ask spread. When the exchanges changed from fractions to decimals a few years ago the market makers got together and created minimum bid x ask spread rules to help guarantee they could continue to make a profit. In the old days a fortune could be made with the 1/8 and 1/16 spreads. Market makers wanted to lock in that same profit potential for the future when the change to decimals came so here is what they did:

OPTIONS UNDER $3 Purchase and Sales can only be done in 5 cent increments

OPTIONS OVER $3 Purchase and Sales can only be done in 10 cent increments

It is not too difficult to understand. If you wish to go in the spread to buy or sell an option it must be done in 5 or 10 cent increments, depending upon whether the option is trading above or below $3.00. In some cases you can even try to place an order to buy for the BID (sale price) and get better than in the spread. Here are some examples of the new spread rules:

BID x ASK $2.90 x $3.00 You can try and get filled for $2.95

BID x ASK $3.00 x $3.10 There is no spread for you to buy into

BID x ASK $3.00 X $3.20 You can try and get filled for $3.10

The important issue to understand is that, before you make your first penny of profit on your trade, you must cover the cost of the bid x ask spread. If the spread is large it will take a larger price movement in your stock to cover this expense.

Looking at the third example above if the bid x ask is $3.00 x $3.20 and you get filled in the spread for $3.10. If you immediately needed to sell the option you would have to sell for $3.00, unless the stock goes up in price. That $0.10 difference is your cost to break even, before the expense of commissions. If the spread is large, say $1, then it takes a much larger move in the price of the stock to cover the spread. If the spread is small, like the one in the example above, $0.10, then it is not an insurmountable issue unless of course the trade goes against you.

A lot of new traders do not take notice of the bid x ask spread when placing their trades. They are not aware of the many dangers of trading and trading options with large spreads. I would recommend if the stock has a large spread that you save that for when you are a more experienced trader, or if you are trading with a proven mentor to hold your hand and help you trade properly. As a general rule of thumb:

NEW TRADERS: Stick to spreads under $0.25 cents until you have had several successful trades and you know what you are doing.

BIG SPREAD TRADES: Stocks that have large spreads, over $0.50, need to be stocks that you have taken the time to study and learn their heartbeat and only play on seriously low supports or high resistance so you really have a lot going for you to have the stocks move in your favor.

Lastly, when placing orders in the spread, I like to use a trading screen like the one offered by www.OptionsXpress.com which gives me the ability to see the exchanges in pink, yellow and green, as shown below. I can then see who has the largest volume and send my order, in the spread, to that exchange. If you are using OptionsXpress.com as your trading firm, you can call them, or use their live online help desk, and ask them to set you up with this feature. It takes about a day or two to set up, but it is free. You will then have access to an order routing pull down menu that will have all the exchanges listed, or you can submit your order the normal way, without selecting the exchange, and OptionsXpress will route your order to the exchange IT believes is the best.


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