The first, and most important step in options trading, is to create a watchlist of highly-liquid, optionable stocks or ETFs. This will be the foundation of your all your trading endeavors. The reason you MUST only use highly-liquid stocks or ETFs is so that you can rely on pricing efficiency.
The more liquid the option the tighter the bid/ask spread. This is extremely important because the bid/ask spread impacts the cost of using options. Wide bid/ask spreads eat into the potential profitability of your investment, and contribute to what is known as ‘slippage’.
The easiest way to search for what we call ‘tradeable’ options on ETFs or stocks — Volume. We look for ETFs with an average volume over 1 million shares traded because we want liquid options. Sometimes the 1 million may not be enough, but it is certainly a good starting point. Again, liquidity directly translates into a reasonable bid/ask spread for options — this is critical. It allows you to trade in and out with giving up much of an edge.
Options Trading: Part II
Sometimes, we receive emails asking me to look at a small-cap or penny stock with 50,000 shares traded. For one, most, if any, offer options. Remember, we use a probability-driven approach using various credit spreads in the Options Advantage service. This would be impossible to do with illiquid underlyings.
Lack of volume is the main reason that we do not use individual stocks in our strategies. Most stocks do not offer liquid options. And the ones that do are subject to volatile moves due to unforeseen announcements, earnings surprises, etc. There is no need to take on this type of risk knowing that we can make consistent gains using highly-liquid ETF options.
Also, by limiting the number of underlying stocks or ETFs, you have the ability to focus and become familiar with a select group that will aid in making your trade assumptions. Creating this watchlist will save you lots of time.