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Trade liquid options and save yourself added cost and stress. There are plenty of liquid opportunities out there. Have you ever compromised your risk tolerance to make up for past losses – "doubling up"? |
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Trading options smarter |
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I’ve heard many option traders say they would never do something: "…never buy really out-of-the-money options!", "…never sell in-the-money options!" But it’s funny how these absolutes seem silly – until you find yourself in a trade that’s moved against you.Believe me, I’ve been there. Facing this scenario, you’re often tempted to break all kinds of personal rules, simply to keep on trading the same option you started with. Wouldn’t it be nicer if the entire market was wrong, not me? As a stock trader, you’ve probably heard a similar justification for "doubling up to catch up": if you liked the stock at 80 when you bought it, you’ve got to love it at 50 – so buy more and lower the net cost basis on the trade. Be wary, though: what makes sense for stocks might not fly in the options world. How can you trade smarter? "Doubling up" as an options strategy usually just doesn’t make sense. Options are derivatives, which means their prices don’t move the same or even have the same properties as the underlying stock. Time decay, whether good or bad for the position, always needs to be factored in. When things change in your trade and you’re contemplating the previously unthinkable, just step back and ask yourself: "Is this a move I’d have taken when I first opened this position?" If the answer is no - don’t do it. Close the trade, cut your losses, or find a different opportunity that makes sense now. Options offer great possibilities for leverage on
relatively low capital – but they can blow up just as quickly as any
position if you dig yourself deeper. Take a small loss when it offers you
a chance of avoiding a catastrophe later. Here’s another, more mathematically elegant way to
think about liquidity: it refers to the probability that the next trade is
executed at a price equal to the last one. Of course, IBM is not usually a liquidity problem
for stock or options traders. The problem creeps in with smaller stocks –
take SuperFutureBank, an (imaginary) financial institution with huge
promise, a stock that trades once a week by appointment only. Here’s a popular rule-of-thumb: If you are trading
options make sure the open interest is at least equal to 30 times the
number of contacts you want to trade. For example, to trade a 10-lot your
acceptable liquidity should be 10 x 30, or an open interest of at least
300 contracts.
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