Just because an equity has options available for trading, doesn’t mean it’s a good idea to trade those options. There are some equities with “good” option chains and some equities with “bad” option chains. A trader should look for five key characteristics before picking an equity for option trading.
#1 Tight Bid/Ask Spread
The Bid/Ask Spread is an indication of liquidity (i.e., how easy is it buy or sell your option.) As a rule of thumb, you want the bid/ask spread to be no more than 5%, and ideally less than 2%. The math for that is: (Ask – Bid) / (Bid)
When you see a bid/ask spread of 20%, that means that each time you get in and out of trade you are giving up 20%. So, if your goal is to make 20%, you need to actually see the trade go up by 40% to overcome the wide bid/ask spread.
This is not only a reflection of how much you are giving up to open and close a position. It is also a reflection of how easy it is to trade an option. With options, it always seems easier to open a position than to close a position. With low liquidity option chains, your order to close a trade may not get filled right away. If the stock moves and the option price changes you’ll find yourself chasing the price, and according to Murphy’s Law, the direction is never in your favor.
Avoid wide Bid/Ask spreads.
#2 Penny Wide Price Increments
You will notice that some options have $0.05 increments between their prices, while others will have only $0.01. That is actually the ” Penny Pilot Program” that began in 2007 with only 63 equities. Now there are 363 equities with penny wide increments. The equities that are in the program tend to be more liquid. Some of the most liquid equities trade with a bid/ask spread of just $0.01 or $0.02 on their options. Those are the options you want to trade!
#3 Option Strikes Available to Trade
When an option is highly traded, you will find that the market demands strike prices at more frequent increments. You may notice that some equities have strikes at increments of $1; others have strikes at increments of $2.50, $5 or $10. This is a function of the stock price and the options trading volume. In general, the more volume, the more strikes you have to choose from. Having more strike prices makes it easier to pick the right trade and to make adjustments, if needed.
#4 Number of Expiration Series Available
The number of expiration series available on an option chain is a function of liquidity and market demand for options. A good example is Apple (AAPL), which currently has 14 different expirations, including four weekly series. Compare Apple to a stock like Qualcomm (QCOM), which only has 6 different expiration series. The different expiration series can be important when finding the right calendar spread trade or when making an adjustment to a trade.
#5 Implied Volatility
Implied Volatility is a reflection of the risk of future movement of the equity. Higher implied volatility means options will be more expensive. It also means there is more risk that the stock will move. The preference of high or low implied volatility is really up to the trader. If you sell options, you would want to sell for a higher price. So generally speaking, you want a higher implied volatility equity. However, some traders prefer lower risk trades and seek low implied volatility. Regardless of your trading style, implied volatility is an important factor when you are evaluating an equity suitable for your options trades.
These are not the only factors that are important when considering an equity to trade. You should still perform your due diligence. But, if you consider these, you can save yourself some headaches and help keep the odds fair.