Penny Stock Options

The Smart Profits Report: Issue #400
Monday, March 5, 2007

Penny Stock Options: The New Pricing System Push Towards Pennies Means The Odds Even Out… And Puts More Cash In Your Pocket
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

The profit party for options companies and market makers is over… but for investors like us, it’s only just beginning.

That’s because at long last, the Securities and Exchange Commission (SEC) is changing the rules and modernizing the way options are priced. This is a great development that truly evens the odds for us - and one that will allow us to claim greater profits with the advent of Penny Stock Options. Let me explain how it works…

The Push Towards Pennies

It’s no secret that the options market is the fastest-growing investment area.

But it’s a sad fact that options often take second place to the stock world when it comes to new changes or improvements. Let me give you an example…

Back in the 1980s, long before the investment arena became fully computerized and high-tech, the archaic systems that brokerages used often meant that stock quotes were inaccurate and didn’t reflect the best bid and ask price (at least not on the Nasdaq). By quoting the average prices of bids and offers, the spreads were very wide.

Needless to say, the market makers had a field day and made money hand over fist. But as trading activity has exploded since the early 1990s, increased volume and competition has resulted in smaller gaps between bids and offers and tighter spreads.

In 2001, the SEC allowed stocks to be quoted in pennies - a move that has greatly benefited investors.

But it wasn’t until early last year that I noticed the SEC trying to do the same thing for the options market - a full five years later. At that time, some options trades were being executed at odd prices. Not in the 5-cent increments that are commonplace, but at numbers like $1.62, when the bid and offer were quoted in round numbers.

It’s taken them a while… but today, the SEC has finally got around to implementing this change in the options world.

Why Penny Stock Options #13 Is The Option World’s Lucky Number

On January 26, the SEC kicked off a six-month pilot program that started pricing certain companies’ options in penny increments (you can find a link to the SEC announcement that officially launched the program in our Cribsheet below).

The test began with Whole Foods Market (Nasdaq: WFMI) and has since expanded across the six options exchanges that prices 12 more of the most widely traded, diverse stock options in pennies. For example, heavyweight companies like Microsoft and General Electric now quote their options in penny increments.

Exchange-Traded Funds (ETFs), like the Nasdaq-100 Trust, also trade in penny increments.

This major move marks the first time that options have been quoted this way, and the SEC expects the pilot to provide valuable information about the impact of pennies on spreads, transaction costs, and quote volume.

And while there are arguments both for and against the penny proposal (which you can read about in more detail in our Cribsheet below), the knowledge acquired during the pilot will be essential to the SEC’s future decisions regarding penny stock options.

Here is a full list of the options currently trading in pennies (in addition to WFMI):

General Electric Company (GE)
Microsoft Corporation (MSFT)
Agilent Technologies, Inc. (A)
Advanced Micro Devices, Inc. (AMD)
Caterpiller Inc. (CAT)
Flextronics International Ltd. (FLEX)
iShares Russell 2000 Index (IWM)
Intel Corporation (INTC)
Nasdaq-100 Trust Shares (QQQQ)
Semiconductor HDLRs (SMH)
Sun Microsystems, Inc. (SUNW)
Texas Instruments Incorporated (TXN)

The question is: What does this intriguing new development mean for you?

Smaller Spread = Larger Profits

Simply put, being able to buy stock options in penny increments means you’re going to record better profits.

Think about an option trade where the quote is $0.25 by $0.30. That means you buy at $0.30 and you can sell at $0.25. That’s a full 20% spread - ridiculous!

When you want to buy an option and see a big spread, the breakeven risk often isn’t worth it. You see, when purchasing an option, not only do you have to predict the direction of the stock or index, you also have to time the purchase well, and have a good idea when it will move in your direction. That in itself is a tough job. But when you also have to overcome a huge spread, it lowers your chances of success even more.

But if the new penny stock option system is implemented across the board, that same option may be quoted as $0.25 by $0.27 - “only” an 8% spread. So you can achieve your profit target more easily - and your losses should also be smaller because of a better fill.

This bodes very well for us in our Xcelerated Profits Report newsletter, where we like to lower our risk and cost by writing covered call trades that involve selling options. By being able to sell in a much tighter market and get filled at much better prices, we’re likely to see our returns enhanced. This applies to spread trading, too.

There is no downside to this latest move. But it sure took us a long time to get to this point!

Don’t Let Brokers Pinch Your Pennies

If your broker won’t allow you to trade in pennies, let him know that you’re aware that some options are now being traded in penny increments.

In fact, there are a few brokers who will allow you to place orders in penny increments today for any option. One of them is Interactive Brokers (www.interactivebrokers.com), which has allowed its customers to place orders in penny increments since October 2006.

Even if the particular option that you’re looking at does not “officially” trade in penny increments yet, I bet my bottom dollar that if you were allowed to place penny orders, you would stand a good chance at being filled

So if your broker won’t let you, need to get an answer. If you go to the Interactive Brokers website, you’ll see that the company has no qualms about entering penny orders for you. So if your broker is “penny pinching” (literally!), perhaps forwarding the link to him would light a fire and change the practice of nickel and dime trading in options even faster.

If you’re a short-term options trader, stick with options that are liquid and have tight spreads (such as the QQQQ’s). This means if you’re wrong, you can exit quickly and minimize your loss. If you’re a longer-term player, buy in-the-money options with very little time premium, so you can let the trade work and not worry about time decay.

Options market growth is measured by contract volume. And the new move to penny increments - which I predict will encompass all companies by the end of 2007 - means options volume will soar. So get ready for another exciting and profitable chapter in options trading with penny stock options. Now all we need is a 24-hour market!

Good trading,

Karim Rahemtulla

Today’s Smart Profits Cribsheet

Over the first six months of 2006 (the latest data available), global options activity jumped by $72 trillion to $370 trillion, compared with $298 trillion at the end of 2005, according to the Bank for International Settlements. That’s a 24% increase in just six months. But here’s the kicker: As recently as 1999, global options activity didn’t even total $72 trillion.

After a five-year legal battle with a global giant who’d infringed on its iron-clad patents, a company we’ve tracked since 2004 just achieved the outcome that now allows it to vault to the front of a $500 billion market. In fact, its groundbreaking technology is so important… it even inked a new deal with the firm it was suing. In addition to existing gains, Xcelerated Profits Report subscribers just banked another 37% gain on the news in 24 hours… even as the market endured another heavy fall. And with the technology already used in a wide range of industries, this up-and-coming industry leader is poised to move higher still from here. To learn more about the firm behind this technology, read this report today.

Here’s the link that was mentioned above about the SEC kicking off a six-month pilot program pricing certain companies’ options in penny increments. And here are arguments both for and against the penny proposal in PDF format.

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