Option Prices

The Smart Profits Report: Issue #261
Tuesday, November 22, 2005

Option Prices: How to Get the Best Price on Your Options
By Steve McDonald
Options Specialist, Mt. Vernon Research

My first day as a stockbroker, my advisor told me what he loved about the business. “You learn something new every day,” he said. And he was right.

I often take for granted how much information stacks up over time. In the 20 years I’ve been trading, most of what I know is the result of having made every mistake imaginable… without somehow ending up broke or unemployed.

And one of the biggest lessons I’ve learned is that if you don’t get the right option prices, no matter how much homework you’ve done, you may never realize gains, even if the trade goes your way. But you don’t always have to pay a premium to buy your options contracts.

Today, I want to show you why the best way to get competitive options prices is with a full-service broker. Let me explain…

First Benefit of a Full-Service Broker: Accurate Option Pricing

I was putting together some option picks recently, and one of the option prices I found online was ridiculous. It had an ask of .55, a bid of .45, and was last traded for .10.

That didn’t seem right to me. Why would I pay .55 for an option that just sold for .10?

I wouldn’t. So in this case, I put the option on my waiting list with hopes its pricing would come down to reality.

As I always do, I checked several other sources online for several hours after the option started trading. No change. On a whim, I called one of the brokers I know to see if he could offer any help.

After giving him the symbol, he came back to me with an ask of .10. In fact, there were several offers on his screen at that price. So, what gives? Why is my screen telling me .55?

Brokers have access to all of the outstanding offers on the market. They can see what all the sellers are asking. So, even though the bid and ask online were far above the last trade, there were still plenty of offers at .10. None of this information was available on the usual online sources.

Not only could the broker tell me what the ask was, he knew how many I could buy at that price and what I would have to pay for more of it. That was news to me. We did not have that ability when I was a broker. We could see the bid, ask, last trade and volume. That’s it.

Guess what price you would have paid if you had put in a market order for this option? .55. And you would have had to pay the same price if you tried to buy five, 10 or even 20 contracts.

Second Benefit of a Full-Service Broker: Lower Option Pricing

Being able to buy anything in large quantities usually gets you a better price. Stocks and options are no different. Brokers can get more competitive pricing, but they can also fill larger orders… and get a discount.

Buying options in small numbers, five or 10 contracts, is the costliest way to trade. This is what is called a “booked trade.” A booked trade is where a small trade is put in by the trader, at the highest price they can legally give you. In the case of my example, that would have been .55. What a deal!

A broker is able to put out an offer to buy a certain number of options at a certain price. Usually, since he or she is buying for several of his clients, they are offering to buy more than an individual investor can. This gives the broker a huge price advantage.

In just about every instance, the broker will get you a better price than you can get online. Even if it’s only .05 less per trade, over a year of trading, that’s huge.

Third Benefit of a Full-Service Broker: A Safety Net

What none of us like to admit are the really big mistakes we’ve made investing. Yes, we saved a few dollars on the commissions doing it ourselves, and yes we lost 10 times that amount as a result of the errors we’ve made. I have some real horror stories about members who have lost thousands because they misunderstood an alert and sold an option instead of buying one.

The most common example I have is of people who buy way too much of a single option, and get crushed when it goes against them. This is almost always the result of inexperience.

Brokers are required by law to tell you when you are doing something that is not in your best interest. In fact, they are required by law to refuse to do something you ask them to do, if they know it is not in your best interest. You can ignore their advice, but you’re fixing something that isn’t broken.

They’re also responsible for any mistakes they make. If a broker enters a sell instead of a buy, it’s his problem, not yours. If they enter a trade for 100 contracts, instead of 10, which is quite easy to do with an online broker, the broker owns the other 90 contracts, not you.

With a full service broker, you have an advisor who can answer your questions about your personal investment issues. They are licensed by the federal government to do exactly that.

Trading options is a tough business. You need all the help you can get. Don’t start each trade in the hole.

Good Trading,

Steve McDonald

Today’s Smart Profits Cribsheet

Getting the best price on your options trades also has a lot to do with knowing the role of the market makers. Karim Rahemtulla, chairman of Mt. Vernon Research, shows us a few tips in Smart Profits #212, Beating the Market Makers on Price, and Smart Profits #191, Outmaneuvering the Market Maker’s Hidden Bid.

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