On Friday, I wrote about the strategies and tactics to best trade ETFs.
Today, I want to focus on the tactical choices we face when trading options…
The tactics for options are different than ETFs. Market makers are more aggressive in the options market. In fact, these market makers will figuratively “rip your face off” if you make a mistake.
So options require more finesse.
Of course, it’s possible to ignore these decisions. You could simply pick which option to trade and then use a market order to enter the trade. This is likely what most option traders start out doing, because markets orders don’t tend to be an issue with stocks or ETFs.
But with options, when using market orders, it’s possible to wind up with a significantly worse trade entry than you expected.
Let me explain…
Two Stats Every Option Trader Must Learn
Market orders are executed immediately, generally near the bid or ask price of the option.
The bid and ask are part of a quote. When we look at the quote for an option, or a stock or ETF, the price we see is where the last trade was executed. But for all assets, there’s also a bid and ask price.
The bid represents the highest price people are willing to pay, and where you should be able to sell at. The ask is the lowest price people are willing to accept for selling, and where you should be able to buy at.
This isn’t shown predominantly on stocks or ETFs, because the bid and ask don’t tend to stray far from the market price in those assets.
For an option, though, the last trade might’ve been executed at $3.15 with a bid of $2.85 and an ask of $3.45. The difference between the bid and ask is called the spread.
Market orders on this option could be executed anywhere between about $2.75 and $3.55. Remember, I said trades occur near the bid and ask. Prices can change suddenly, and those changes will almost always work against you in the options market.
If you tried to buy the option in the example with a market order, the one trading at $3.15, you’d probably pay $3.40 to $3.50. That’s almost 10% more than you expected to pay. You’d face similar costs when it’s time to sell. And market makers pocket a lot of this overpayment when you use market orders.
So to avoid donating to the profits of market makers, you can use a limit order. With a limit order, you are saying you will pay no more than a certain price to buy or accept no less than a certain price to sell.
It’s common to set limits in the middle of the spread. In this example, that would be $3.15. That could lead to better execution.
But — and you probably realize there’s always a “but” when a solution appears to be simple — you don’t know if $3.15 is the fair price for an option. Volatility and other factors conceal an option’s true intrinsic value. (I’ll write about finding the fair price of an option using a simple and free online tool on Friday.)
So in addition to using limit orders, you can also use stop qualifiers for your orders.
Use These Two Tools Instead of Market Orders
A qualifier is an additional instruction you provide to your broker. The limit price is a qualifier. So is a stop price.
Many traders are familiar with stop-loss orders. This type of order is used to sell if the price falls below a certain level. Using these is a bad idea for stocks and ETFs… and a terrible idea for options.
A market maker’s job is to execute open and unfilled trades in the market. If you have a stop-loss order pending, it’s their job to execute the trade — no matter if you intended the stop loss as a risk measure.
In other words, a market maker will do all they can to ensure you get hit your stop loss. With the wide spreads in options, they can hand you that loss pretty quickly, without much effort, and even if the quoted market price is above your stop.
A less well-known qualifier is the stop-buy. This is an order with a stop price above the current market price.
In our example (last, $3.15; bid, $2.85; ask, $3.45), you could enter a stop at $3.25, limit $3.30. This trade will only execute if the bid moves to $3.25 and will be executed at $3.30 or better.
The stop qualifier requires the market to move in your direction before trading. And the limit price helps you avoid getting your face ripped off with a poor execution.
The stop-limit is my default entry tactic. But there are times when a market order makes sense in highly liquid options like those on the SPDR S&P 500 ETF (SPY). There are also times when market orders can be used, like on exits, provided the option is adequately liquid.
There’s still a lot to cover on the tactics of trading.
In our next discussion on tactics, I’ll cover finding the fair value of an option so you can trade near the best price.
We’ll follow that up with some techniques on selecting the right option to trade. This should provide an overview of all the tactical decisions required to trade options effectively.
Michael Carr, CMT, CFTe
Editor, One Trade
Chart of the Day:
Tesla Is Taking Over
(Click here to view larger image.)
Building off of the unusual activity Chad spotted yesterday, today’s chart adds even more fuel to the bullish argument for Tesla…
This is a ratio chart between Tesla and the Nasdaq 100 index. As it goes up, Tesla makes up more of the index’s value. As it falls, it takes up less. Essentially, this chart shows when Tesla is outperforming all other companies in the Nasdaq.
You can see how Tesla spent much of 2020 taking up more and more of the Nasdaq 100 pie. It then topped out in the first week of January this year, as TSLA came close to cracking $900 per share.
Tesla then spent 2021 losing value against the broader Nasdaq 100, but it’s staged a comeback in recent weeks, breaking two key downtrend resistances. And it’s important to note that this ratio chart’s weekly RSI hasn’t even gone into overbought territory yet.
I think we’ll see this chart attempt to clear the 0.07 level before the year is out. If history decides to repeat itself, we could see another blow-off top in this ratio pair in the first week of January 2022.
In other words: ignore the bears and serial short sellers. You want to be bullish on Tesla here.
Managing Editor, True Options Masters