Reading Option Chains

The Smart Profits Report: Issue #172
Tuesday, January 04, 2005

Reading Option Chains: The "Fail Safe" Trading Signals Revealed
By Mt. Vernon Research Team

This morning I got an e-mail from a guy telling me not to make a great trade he’d just spotted. Huh?

I have to wonder why the writer wasted his time. It wasn’t an educational column; it was a "trade alert." Supposedly. This is rather like the newspaper reporting that it didn’t rain and the fireworks weren’t cancelled last night. Journalists dub that "negative news," and any good one would call in sick before writing such claptrap.

The stock in question supposedly had great technicals. (I think the writer got that wrong, as it was still below bear resistance and trading in a range. It’s on my bullish watch list, but is still a dollar short of breakout.) But, he warned, much as he loved it, it was thinly traded and the spreads were too big when reading option chains.

As Charlie Brown would say, "Arrrgh."

Option Chains: Thinly Traded Might Be a Good Buy Signal

The goofiness I hear over volume and "thin trading" makes me want to pull out my hair sometimes. Yes, it is a concern, but it seems 90% of traders get it wrong. That includes at least half the "professionals," too.

Out of curiosity, I went to an options chain for the stock to see what the story was today. Let’s just say for our example - this is a pretend price in the spirit of using aliases to protect the innocent -that this was a stock that was just over $36. You could take an in-the-money call at $35 or an out-of-the-money call at $40.

Was it thinly traded? Well, sort of. The market was closed, and… whaddyaknow! Nobody was trading it! Now there’s a revelation.

In fact, the market had been closed for three days for the Christmas holiday. This was a "Christmas stock." It was one that analysts would be watching to see whether its holiday sales did well. Moreover, that means that not many people were trading it right before Christmas because its seasonal news was due to come out days from now. Everybody who wanted to be in place based on the available information had already done that a week and a half earlier when it last had news.

The market opened, and sure enough, not many people were biting. So right now, you could say it’s thinly traded. But contrary to our friend’s analysis, this is precisely when I’d consider buying in… If I liked the stock’s chances, I’d be on it. When it begins to be heavily traded again, it’s going to get expensive.

Why? Options prices go up when surges of demand come in - Capitalism 101. In options, the idea is to get there when the crowd is pessimistic, with the right idea, and profit when the late-wakers catch on.

Looking at daily volume on only one or two option contracts is an excellent idea - for people who like to lose their money quickly instead of taking the longer route via buying hopeless tech stocks. I applaud the people who do it, though, because they make my job easy.

Okay. You suspect there’s a better way, right? You bet. First of all, you have to answer the question "what is adequate trading?"

Watching The Underlying Stock on Option Chains

Not long ago, I listened to another trader (a very good one) say he no longer recommends options on stocks that trade less than 3-4 million shares per day. His readers buy options in volume and he has a big list. Plus, they veer toward the day-trading end of the spectrum and profit from relatively small but fast changes in price. So he doesn’t want his recommendations to push the option price even a half percent.

There are two very valuable clues in his statement.

First, it is the activity of the underlying stock that matters most.
Second, he defined volume in terms of his situation, not abstractions.

When I recommend trades, I don’t need that much volume. My trades last a week to three months, and I’m looking for strong gains over that longer period, not dozens of small day-trading gains. And my list is relatively small compared to the fellow who needed 4 million shares a day to get into a trade without moving it. I usually look for stocks trading about a million or more shares a day, but can go down to 500,000 shares without stress as long as there are plenty of options and they’re well followed. If I were writing an advisory service for only 12 people, I could trade just about anything. Of course, the subscription fee would be outrageous.

If you are generating your own trades, you don’t have to worry about fellow subscribers acting the same time you do. Any stock that trades 300,000 shares or more a day and has sufficient open interest - which we’ll come to - will do.

Because after looking at the stock, there’s another step to take… looking at the option chain, the whole darned thing.

Buying In Volume? Save It for Wal-Mart… Here’s Why

There are many good and non-lethal reasons why volume might be low on any given day in a particular month and strike price. Perhaps while you are looking at February options, most people are queuing up for April or July ones. Maybe you like the in-the-money option, but a farther-out one is getting all the attention. Maybe today’s the day the market is fixated on chip stocks and all the retail stocks or insurance stocks are temporarily out of the limelight. Maybe you are even bullish for good reason while everyone else is still bearish, or vice versa.

But if you look at, say, a March call, and see little activity there while there are lots of takers for February and April options, you need not fear March. If you want the $25 call and see lots of activity at the 22.5 and 30 strikes, even if the 25s aren’t getting much attention, you need not fear the 25 strikes. If you are the only one buying a March 30 call but traders are piling into the March 30 puts, you don’t have to worry about liquidity.

It’s a CHAIN: when the 22.5 strike goes up and the 30 strike goes up, the 25 is going to move in the same direction, generally speaking. When the February put moves up and the June put moves up, the March put will, too. You don’t have to be in the same contract everyone else is buying. Their nearby interest is in your interest.

And most of all, if open interest is strong, who cares what today’s volume is?

Volume could mean lots of people are getting out instead of getting in, anyway.

Volume is how many people are taking trades on an option today - in or out. It’s a one-day snapshot stat.

Open interest is how many contracts are out there altogether. It’s by far the more important number, because when your option shoots up 100%, all those other players are going to have the same instinct you have. Even if some of them did buy on days when the volume was 200 and some when the volume was 5.

Spreads: If You Can’t Make 20% Without Even Trying… Don’t Try!

As for spreads, well the writer of the hapless bulletin was partly right. The spread between the bid and ask was about 11-12%. Most of the time, they range from 5% to 10% on reasonably active stocks. Fifteen percent is not uncommon.

I only worry when it’s more than that. And remember, a mere 2% move in a stock can easily translate to a 10-30% move in the option. Frankly, if I didn’t think I could cover a 10% spread, or even a 12% spread, I wouldn’t be trading options at all. Spreads and commissions are a fact of life.

Besides, even if the spread is narrow, a mere 5% on the day you buy your option, it can, and often does, widen later to your detriment. You can almost count on the spread changing even when things are going right. Especially then. If you’re bullish and have a call while the stock starts rising rapidly, you will see the option’s ask price go up somewhat faster and earlier than the bid price. The spread widens when the market maker sees he’s going to have to start paying off. It happens all the time. That’s something you have to live with. Your system had better allow for it.

For instance, I never take a trade without calculating my potential risk and reward first. And unless I think I have an easy 20% gain to cover the spread - even if it widens later - PLUS another 50% or more on top, I wouldn’t even consider the trade. Often, I see that spread covered the same day. That’s options.

That’s what you should expect from short-term options trading. Don’t worry so much because there are obstacles. That’s like saying you could be a great hurdler if it weren’t for the fences you had to jump. Instead, understand what the challenges are and make sure your system is built to cover them.

Economists like to say there is no free lunch. There are none in the options market. There aren’t even any cheap sandwiches. Then again, there are lots of double- and triple-decker wins with caviar on top, which makes the risk worth the rewards.

Good trading,

Mt. Vernon Research

Today’s Smart Profits Crib Sheet

For more about liquidity in options, check out Smart Profits #116, Liquidity & Limit Orders: An Options Balancing Act.
Also, for any definitions to terminology used in today’s issue, like "limit price" or "spread trade", check out our Smart Profits Glossary.

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