Featured Article

Compromises

josipcausic
Josip Causic
Instructor

In this article, I will compare two trades; one mine, and one from a trader who shared his trade with me asking for my take on it. The trades were very similar in a sense that the underlying products were optionable and they both had weekly options listed. They also both had individual strike prices with very little or no open interest and volume. Should we even be considering trades on options like these that have such low liquidity?

Weekly WMB trade January 2012 Week A

The first trade was on the WMB in which a trader had noticed a great technical setup. Basically, it was an All-Star Entry, which many of our Online Trading Academy students are familiar with. For those who aren’t, contact your nearest Online Trading Academy center to find out about our classes.

 

How to read an options chartFigure 1: WMB Daily chart

The stock gapped four Standard Deviations down, and the trader executed a Buy-Write Covered Call strategy. He simultaneously purchased 500 shares of the WMB stock for 27 and sold five weekly 29 calls on it for 2.50 per contract. His BEP (Break Even Point) was 24.50 (27 – 2.50). When he contacted me, he was quite surprised that his weekly options that had only four more days of life span left had such rich premium. The Jan Week A options were expiring on Friday the 6th, and for him, all that needed to happen to keep 2.50 credit was that WMB stay below 29.

I was able to see his footprint on Time and Sales because that particular weekly 29 call did not trade many contracts that Tuesday morning, 01/03/2012.

 

comparison of two options tradesFigure 2: WMB Time & Sales

Because of the lack of Open Interest and Volume on the individual strike prices, this trade does not fit Online Trading Academy requirements for an options trade. However, the bottom line is that the trade worked out perfectly. On the 6th, the stock closed at $27.39 and the trader made a profit of 0.39 per share, plus he kept all the credit he received from selling the 29 calls.

Weekly XEO trade January 2012 Week B

Similarly, in my trade on the XEO (European style S&P 100), the setup looked great technically. The XEO was trading below the 590 level and strongly above the 565 level. However, the Open Interest and Volume on the individual strike prices of these weekly options were quite low. The question that I had in mind on that Thursday morning (01/05/2012) when Jan Week B options were listed was, “Do I talk myself out of a perfectly reasonable trade, technically, because of the lack of option liquidity?” Ultimately, the decision had to be made based on the question of whether the trade was worth the risk taken. (Or as some traders say: Is the pay off worth the aggravation?) In my opinion, the answer was yes; however, I did first send in a foot soldier (a single contract) to discover what the best possible price was that I could get for my 595/590/565/560 Iron Condor. Initially, I asked for a credit of 1.45, then 1.40, then 1.35, but it was only at 1.30 that I was finally filled. Next, I sent in the order with my troops (10 contracts) to be filled at the same price, which they eventually were.

 

iron condorFigure 3: Four Time and Sales of XEO week B options

Those familiar with the Iron Condor strategy know that I risked only 3.70 (5.00 spread minus the credit) to make 1.30. For a directional trade, this would not make any sense because more is being risked than what the potential reward is. However, this Iron Condor was a non-directional trade so the bottom line of what is at risk needs to be taken into account. Between Thursday morning (01/05/2012) and Friday (01/13/2012) close, the XEO could trade anywhere as long as it did not close above 590 or below 565. At the entry, the XEO was at 580, and on the last day, it closed barely above 580.

The risk to reward on this trade can be calculated (1.30/3.70) to get the rate of return on this investment; in this particular case, 35% within a week.

 

options trade resultsFigure 4: TOS Trade Tab

This last figure shows the outcome for the XEO trade. However, let us go back to the original question: Could I have talked myself out of a perfect technical setup because of the lack of option liquidity on the XEO? Could anyone?!?

In conclusion, a lack of Open Interest and Volume on individual strike prices is often associated with a lack of liquidity. However, if we are sellers of options and “the price is right” (just like the TV show), then occasionally, it is acceptable to (option) trade in such an environment. As long as we are aware that if we are wrong and need to buy back our obligation, we will have to take full responsibility for our actions; in other words, pay a higher premium price because of the slippage. Ultimately, everything comes down to whether we are trading on a good technical setup or not. Sometimes you do not have to talk yourself out of a good trade because of some small imperfections.

– Josip Causic

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.