Option Basics: How to Enter and Exit Option Trades

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Option Basics: How to Enter and Exit Option Trades

 

Dr. W. Edward Olmstead

Chief Options Strategist

Olmstead Options Options Strategies

 

 

Very often the success of an options trade will be strongly influenced by how carefully the entry and exit prices are negotiated. The gain or loss of $.10 per share in a stock trade is usually insignificant, whereas in an option trade it can make a huge difference. Suppose that you buy an option for $2.00 per share and later sell it for $3.00 per share. The profit of $1.00 per share represents a nice 50% return on your investment. If you could have shaved your entry price by $.10 to $1.90 and managed to pad your exit price by $.10 to $3.10, then your profit of $1.20 per share represents a dramatically improved 63% return.

 

The point here is that, in options trading, it is very much worthwhile for you to work at achieving good entry and exit prices. Saving an extra $.10 on either the entry price or the exit price of a trade is usually enough to cover the brokerage fees on both ends of the trade.

 

To begin, let’s review the basics of how options prices are maintained:

 

The current decimal pricing of stocks and ETF’s is such that the price per share is typically quoted in $.01 increments. You will see this same pricing structure on some options, but certainly not all. Those options that cost less than $3.00 per share are typically priced in increments as small as $.01, although this is not always available. For options that cost $3.00 per share or more, the pricing will often be in $.05 increments, but here again there will be exceptions. For some high volume stocks and ETF’s with very liquid options, you may see $.01 increments in the pricing of its options that cost over $3.00 per share.

 

Each option exchange will list a bid price (called the “Bid”) and an ask price (called the “Ask”) for every option that is available on a stock or ETF listed with that exchange. The Bid is the highest per share price that some trader (or market maker) is willing to pay to buy the option. The Ask is the lowest per share price that some trader (or market maker) is willing to accept for the purchase of an option. Most financial data feed services that provide options prices show only the best Bid and best Ask prices as selected from a survey of all the exchanges.

 

The Ask is always greater than the Bid and the difference between the two prices is called the Bid/Ask spread, or more simply the “Spread.” Depending upon the liquidity of the option, the Spread may be as narrow as $.01 for options trading under $3.00 or as wide as $1.00 or even more for some illiquid options. Whenever the Spread is wide enough, there is the possibility of negotiating a more favorable price somewhere between the Bid and the Ask.

 

Be wary of situations in which the Spread exceeds 15% of the average of the Bid and Ask prices. In such circumstances, check recent volume in the options to make sure of sufficient liquidity to justify trading them.

 

The width of the Spread for an option is essentially controlled by the market maker. He earns his living by managing an appropriate Spread. His goal is to have someone buy an option from him at the Ask, while someone else is willing to sell him the same option at the Bid. The two option positions cancel each other and the market maker pockets a profit equal to the value of the Spread. This may seem like a small profit if the Spread is only $.01 to $.05, but when repeated over a large number of contracts it soon becomes substantial.

 

In a non-volatile situation where there is a high volume demand for both buying and selling an option, the market maker is content with a narrow Spread, because it is easy to match up his long and short positions while repeatedly collecting the value of the Spread. In a highly volatile situation where there is a large but unbalanced demand for an option, or in a very low volume situation, the market maker maintains a wide Spread. In those situations, it is more difficult to find a matching trade and the market maker needs a wider Spread to offset his risk.

 

 

Now let’s turn our attention to the details of entering and exiting a trade. For simplicity, we will confine our attention to the opening and closing of a long option position. That is, first buy an option in an “opening transaction” and then later sell the option in a “closing transaction.”

 

 

Entering a Trade

 

There are two main ways to initiate an “opening transaction” for an option trade. Similar to buying stock, the purchase of an option is typically accomplished by means of either (i) a market order or (ii) a limit order.

 

Most option traders avoid a market order in an “opening transaction”. The best that you can do is to be filled at the Ask price, and quite often you will do worse. If your order is for several contracts, you may find that only a few contracts are filled at the Ask before that price slides to a higher level for the remaining fills.

 

In a volatile market where option prices are changing quickly, you may feel that you will only succeed in entering the trade by the use of a market order. In such a situation, you will be placing yourself at the mercy of the market maker, who is allowed considerable latitude in filling market orders during fast conditions.

 

This leaves the limit order as the principal way to buy an option. With the limit order, you select the price that you feel is reasonable to pay for the option and enter that price with the order. There is no guarantee that your order will be filled, but if it is, it must be at your price or lower. Let’s look at some examples to illustrate how to determine an appropriate price for a limit order to enter a trade.

 

Example #1A: Bid = $2.40 and Ask = $2.42. There is almost no room for negotiation here. The Spread = $.02, which is almost the minimum possible for an option trading under $3.00 per share. Typically, the Spread is this tight only for highly liquid options. Place a limit order to buy at $2.42 and you should get a quick fill.

 

Example #2A: Bid = $2.40 and Ask = $2.60. With the Spread = $.20, there is some room for negotiation. You could try to split the Spread in the middle with a limit order to buy at $2.50. Getting filled at that price under most conditions could be difficult. If you move the limit price up to $2.55, you are much more likely to get filled.

 

Example #3A: Bid = $4.10 and Ask = $4.40. Since the option is trading over $3.00 per share, the minimum Spread might be no smaller than $.05. Here the spread is $.30, which suggests that there may be some room for negotiation. Typically, a limit order to buy at $4.20 is pointless, because you are asking the market maker to give up more than half the spread. A more realistic approach would be to place a limit order at $4.30. This gives the market maker a $.20 Spread, which should be enough to get the trade filled.

 

Example #4A: Bid = $8.50 and Ask = $9.10. With a Spread = $.60, this is what you might see for a deep-in-the-money option that trades lightly. The market maker isn’t really interested in trading this option, but if you insist, he is going to make it worthwhile for himself. In this type of situation, be prepared to struggle to get a decent fill price.

 

 

Exiting a Trade

 

When exiting an option position, it is called a “closing transaction.” As with entering a trade, this can be done by means of either (i) a market order or (ii) a limit order. There are two additional ways to exit an option trade that are worthy of discussion, namely (iii) a stop loss order and (iv) a stop limit order.

 

Most option traders use a market order to exit a trade only in extreme situations where it seems imperative to exit a trade immediately to avoid substantial loss. Keep in mind that the fill price you receive on a market order to sell an option will not be any higher than the Bid and will often be significantly lower.

 

When using a limit order, the situation is analogous to that of entering the trade. You select a price that you feel is reasonable to sell your long option and enter that price with the limit order. You may not get a fill, but if you do, it must be at that price or higher. Let’s re-examine the above examples #1A – #3A to illustrate how to determine an appropriate price for a limit order to exit a trade.

 

 

 

Example #1B: Bid = $2.40 and Ask = $2.42. Again, there is no room for negotiation here. The Spread = $.02, which is almost the minimum possible for an option trading under $3.00 per share. Place a limit order to sell at $2.40 and you should get a quick fill.

 

Example #2B: Bid = $2.40 and Ask = $2.60. With the Spread = $.20, there is some room for negotiation. You could try to split the Spread in the middle with a limit order to sell at $2.50. Getting filled at that price under most conditions could be difficult. If you move the limit price down to $2.45, you are much more likely to get filled.

 

Example #3B: Bid = $4.10 and Ask = $4.40. Since the option is trading over $3.00 per share, the minimum Spread might be no smaller than $.05. Here the spread is $.30, which suggests that there may be some room for negotiation. Typically, a limit order to sell at $4.30 is pointless, because you are asking the market maker to give up more than half the spread. A more realistic approach would be to place a limit order at $4.20. This gives the market maker a $.20 Spread, which should be enough to get the trade filled.

 

Next, let’s examine the use of the stop loss order for selling an option. With this order, you indicate a trigger price at which you want the order to be initiated. The order to sell is then activated when either (i) the option trades at the trigger price or lower, or (ii) the Ask is at the trigger price or lower. Once the order is activated, it becomes a market order to sell the option. As with a straight market order, this means the fill will not be any better than the Bid when the order is activated and it may be substantially worse. Avoid using this type of order unless trying to avoid substantial loss.

 

Finally, let’s consider the stop limit order for selling an option. As with a stop loss order, you indicate a trigger price at which you want the order to be initiated. But here you also indicate a limit price at which you wish to sell your long option. The order is activated under the same two conditions described above for the stop loss order. The difference here is that once the order is activated, it becomes a limit order to sell at the price you selected.

 

Getting filled on a stop limit order can be tricky. You must carefully select your trigger price and your limit price in order to give yourself the best opportunity for a fill. If you set the limit price too close to the trigger price, you may not get a fill in circumstances where you definitely want to be filled. Let’s look at an example:

 

Example #1C: You have a long call that is currently trading at $4.00. You want to try and protect this position with a stop limit order so that you will sell this option for no less than $3.50. Let’s see what might happen if you set a trigger price of $3.60 and a limit price of $3.50. Suppose it occurs that the option price drops until the Ask = $3.60 and the Bid = $3.40. Since the Ask has reflected your trigger price, your limit order to sell at $3.50 is then activated. Unfortunately, you will not get a fill here because the Bid is lower than your limit price.

 

To avoid this situation, the gap between the trigger price and the limit price should be adjusted to reflect the anticipated Bid/Ask Spread when the order is activated. In this example, it looks as if the trigger should have been set at $3.70 so as to account for the Spread = $.20. Then, if the option price drops until the Ask = $3.70 and the Bid = $3.50, your order to sell will be activated with a limit price which is the same as the Bid. This provides a much better chance of being filled at your desired price of $3.50.

 

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Dr. Olmstead can be found at http://www.olmsteadoptions.com/options_blog/, an on-line options trading community, centered on options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com