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Ask Trader Guy: When It's Not a Good Time to Trade Options

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October 1, 2011
tradings stock and options
Fredrik Broden

Q: Do you ever decide to trade the stock itself instead of its options?

A: Assuming that the stock has options (not all of them do), the answer is yes. There are two circumstances where I trade the stock and not the options, assuming that I’m speculating on the stock’s direction. The first is when the options have very little trading activity and/or very wide bid/ask spreads, meaning it’s tough to enter and exit positions at close to fair value. When there’s very little trading activity, you’re at the mercy of the market maker. When there is lots of activity, there’s a better chance to get filled at a price in between the bid/ask spread. I like to see a good level of option volume and open interest before I enter, because I know I might have to exit, and I want to get good executions on both sides.

The second is when the stock is trading at, say, less than $2. Now, that’s a somewhat arbitrary number, but if you buy 100 shares of stock for $200, your max potential loss is $200. One of the reasons I like to use options, and option spreads in particular, is to reduce my maximum potential loss. In higher-priced stocks, option spreads can have a lot less risk than an outright position in the stock. But if the stock itself has a very low price, there’s not much more risk in buying 100 shares of stock for $2 a share than some option spread for $150. And that’s assuming that there are enough actively traded options in that low-priced stock to even do a spread. Plus, the stock doesn’t have an expiration date. You can hang on to that low-priced stock as long as you want in the hopes that it will go up someday. You can’t do that with options.

Q: How do I start to work option trading in with my stock portfolio?

A: You might be a stock investor looking to generate extra income on your portfolio, or hedge it, or establish new positions using less capital. Once you’ve educated yourself on the strategies and tactics and their benefits and risks, start small. Really small. Smaller. No matter how big your account is, start with two spreads, two options. No more. Why? When you start out, you’re likely to make mistakes that cost you money, and you’ll learn from those mistakes whether you trade a 2-lot or a 200-lot. So keep the “tuition” low. If two’s too much, you could start with one. But why two instead of one? You might want to try closing half of a position— whether to lock in a profit or a loss, or take off risk. You can’t do that with one contract.

Now if one contract is too much, then start with paperMoney™ on thinkorswim™. By trading fake money on the real platform (it’s virtually identical) , during market hours, you’ll get a sense of how you might react when you have real money on the line.

Only when you’ve gained experience with winning and losing trades, and have built confidence in your ability to execute trades efficiently and manage positions and risk effectively, should you start to increase the size of your option positions—very slowly.

Q: Bacon has become too “public.” What’s the next meat, cured or otherwise?

A: I have to confess I agree with you. When bacon started popping up in all the magazines at the supermarket checkout, I quietly put five of the six packages back on the shelf. I’m thinking the next thing is ham steaks. They’re pork. They cook up quick. They’re versatile. You can fold them around other ingredients like a tortilla. Get the napkins ready...