On Friday I wrote about strategies and tactics to better trade ETFs.
Today I want to focus on the tactical choices we face when trading options…
The tactics for options are different from those for 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.
The options therefore require more finesse.
Of course, it is possible to ignore these decisions. You can simply choose the option to trade and then use a market order to enter the trade. This is probably what most options traders start to do, as market orders don’t tend to be a problem with stocks or ETFs.
But with options, when using market orders, it is possible to end up with a much worse trade entry than you expected.
Let me explain …
Two statistics every options trader should learn
Market orders are executed immediately, usually near the option’s bid or ask price.
Supply and demand are part of a quote. When we look at the listing of an option, stock, or ETF, the price we see is where the last trade was executed. But for all assets there is also a bid price and a ask price.
The auction represents the highest price people are willing to pay and at which you should be able to sell. Demand is the lowest price people are willing to accept to sell, and where you should be able to buy.
This does not appear primarily on stocks or ETFs, as supply and demand do not tend to deviate far from the market price of these assets.
For one option, however, the last trade could have been executed at $ 3.15 with an offer of $ 2.85 and a request of $ 3.45. The difference between supply and demand is called the spread.
Market orders on this option could be executed anywhere in between about $ 2.75 and $ 3.55. Remember I said trade happens near supply and demand. Prices can change suddenly, and those changes will almost always work against you in the options market.
If you try to buy the option in the example with a market order, the one that is trading at $ 3.15, you will likely pay $ 3.40 to $ 3.50. It’s almost 10% more than you expected to pay. You would face similar costs when it comes time to sell. And market makers pocket a lot of that overpayment when you use market orders.
So, to avoid donating to the profits of the market makers, you can use a limit order. With a limit order, you say you won’t pay more than a certain price to buy or accept less than a certain price to sell.
It is common to set limits in the middle of the spread. In this example, that would be $ 3.15. This could lead to better execution.
But – and you probably realize that there is always a “but” when a solution seems simple – you don’t know if $ 3.15 is the right price for an option. Volatility and other factors mask the true intrinsic value of an option. (I’ll write on Friday about finding the right price for an option using a simple, free online tool.)
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 that you provide to your broker. The limit price is a qualifier. The same goes for 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 them is a bad idea for stocks and ETFs… and a bad idea for options.
The job of a market maker is to execute open and unexecuted trades in the market. If you have a pending stop-loss order, it’s their job to execute the trade, regardless of whether you’ve designed the stop-loss as a measure of risk.
In other words, a market maker will do whatever it takes to make sure you get your stop loss. With wide option spreads, they can cause you to suffer this loss fairly quickly, without much effort, and even if the quoted market price is above your stop.
A lesser-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 can enter a stop at $ 3.25, limit $ 3.30. This trade will only be executed if the offer goes 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 ripped off with poor execution.
Stop-limit is my default entry tactic. But there are times when a market order makes sense in very liquid options like those of the SPDR S&P 500 ETF (SPY). There are also times when market orders can be used, such as on exits, provided the option is sufficiently liquid.
There is still a lot to cover on trading tactics.
In our next discussion of tactics, I’ll cover finding the right value for an option so that you can trade near the best price.
We will follow that up with some techniques on selecting the right option for trading. This should provide insight into all of the tactical decisions needed to effectively negotiate options.
Michael Carr, CMT, CFTe
Editor, A job
Card of the day:
Tesla takes over
(Click here to enlarge the image.)
Building on the unusual activity Chad spotted yesterday, today’s chart adds even more fuel to the bullish argument for Tesla …
This is a ratio graph between Tesla and the Nasdaq 100 index. As it increases, Tesla accounts for a larger portion of the index’s value. As he falls, he takes less. Essentially, this chart shows when Tesla outperforms all of the other Nasdaq companies.
You can see how Tesla spent much of 2020 taking more and more of the Nasdaq 100 pie. It then peaked in the first week of January this year, as TSLA hovered close to $ 900 a year. action.
Tesla then spent 2021 losing value against the wider Nasdaq 100, but it has made a comeback in recent weeks, breaking two key resistances to the downtrend. And it’s important to note that the weekly RSI on this ratio chart hasn’t even entered overbought territory yet.
I think we’ll see this chart attempt to clear the 0.07 level before the end of the year. If history decides to repeat itself, we could see another high explode in this pair of ratios in the first week of January 2022.
In other words: ignore bears and serial short sellers. You want to be optimistic about Tesla here.
Editor-in-chief, True masters of options