If a stock, ETF, or currency, i.e. underlying has options available for trading, that doesn’t mean it’s a good idea to trade those options. There are some equities with tradable option chains and some equities with untradeable option chains. A trader should look for the following characteristics before picking an underlying to trade options. The reason why this matters is that a lack of liquidity can easily cost more than trading commissions. The following are the best qualities of options to trade:
#1 Penny Wide Bid/Ask Increments
A Bid is the price at which an option can be sold and the Ask (or offer) is the price at which an option can be bought. The difference is referred to as the “Bid/Ask spread” which is an indication of what is commonly referred to as liquidity i.e., how easy is it to buy or sell an option. Some options have minimum $0.05 increments between their bid/ask, while others will have only $0.01. This started with the SEC’s “Penny Pilot Program” that began in 2007 with only 63 equities. Now there are 363 equities with penny wide increments. The equities that are in the program are often the most liquid options available. Some of the most liquid underlyings trade with a bid/ask spread of just $0.01on their options. These are the most liquid options to trade. For a list of these options, click here
If you want to trade a stock without a penny wide bid/ask, as a rule of thumb, you want the bid/ask spread to be no more than 5%, and ideally less than 2%. The math for that is: (Ask – Bid) / (Bid)
When you see a bid/ask spread of 10%, that means that each time you get in and out of trade you are giving up 10%. So, if your goal is to make 10%, you need to actually see the trade go up by 20% to overcome the wide bid/ask spread.This is not only a reflection of how much you are giving up to open and close a position. Avoid wide Bid/Ask spreads.
When an option is highly traded, you will find that the market demands strike prices at more frequent increments. You may notice that some equities have strikes at increments of $1; others have strikes at widths of $2.50, $5 or $10. This is a function of the stock price and the options trading volume. In general, the more volume, the more strikes you have to choose from. Having more strike prices makes it easier to pick the right trade and have the option likely be more responsive to price movement.
The number of expirations available on an option chain is a function of liquidity and market demand for options. A good example is Apple (AAPL), which currently has 14 different expirations, including four weeklys. Compare Apple to a stock like Fastenal (FAST), which only has 6 different monthly expirations. The different expirations can be important when finding the right spread trade or when rolling i.e. moving an option to another expiration.
These are not the only factors that are important when considering an underlying to trade. You should still use candlestick charting techniques to find ideal setups. But, if you consider these, you can save yourself some headaches and help keep the odds fair.
Learn more about combining Japanese candlestick charting techniques with options.