Option Trading Basics Bootcamp – [Week 1]

• stevenplace
• September 21st, 2011

I’d like to welcome you to the introductory lesson of what’s called “Option Trading Basics Bootcamp” This will be a weekly course on how to avoid the most serious pitfalls many new option traders encounter in the options market.

Trading stock options can lead to significant gains, but you can also lose your shirt if you don’t understand the mechanics of the market and options pricing.

This bootcamp was created as an introductory options training course for beginning option traders, and the principles I talk about are not always used as you become a more advanced options trader. Still, these principles are incredibly helpful, especially if you are just starting out in the options market.

Why I should be your drill instructor

I’ve been running an option trading service for about 3 years now, and I also have developed a video options training course, and both have given members spectacular increases in their trading ability. But I often see new option traders make the same mistakes over and over.

I believe option trading mistakes follow Pareto’s law — that 80% of your trading losses come from 20% of your mistakes. If you can correct the right mistakes, your trading success will be leveraged and you will see that “breakthrough” many traders hope to find.

Today I’m going to give you the simplest, most actionable principle that you can apply to your options trading today. Are you ready?

Principle #1: Never Use Market Orders

This is by far one of the biggest mistakes new option traders make when they are first starting out. You may think the options market behaves like the stock market, but that is not the case.

When dealing with options you may see options trading in penny or nickel increments, but remember that option contracts are standardized for 100 shares. When we look at the market, we can see the bid and the ask will often have a difference of .05 to .25, so that means the bid/ask spread is much wider than on first glance.

Because options can act as leveraged instruments, the bid/ask spread can affect your position much more compared to stocks. On top of that, if the options you are trading lack liquidity, it can have a very wide bid/ask spread, which means it’s very important to get the best fills you can.

Order Types

The two basic kinds of option orders are the limit order and the market order. A limit order provides liquidity to the market, but gives you no guarantee of getting filled. A market order reduces liquidity in a market, and you are filled every time.

Since there are many different option chains in many different markets, there will never be a centralized source of liquidity. Compare that to equity futures like the ES, which will always have a tight bid/ask spread because it is so heavily traded and liquid.

The table above is a market depth screen for a call option on $WYNN. Notice that the bid is 4.10 and the ask is 4.35. That is a $25 difference, or about 6% of the current value of the option! If you don’t use the right option order you could already be down 6% on the position.

As a new option trader, putting market orders in on a stock option tells me one thing: you are forcing yourself into a market. If you are forcing an order, that means you are feeling rushed, that you are missing out on a trade or that you fear missing any potential gains. This fear has led to many dumb trades– I know, I’ve been there.

The best tactic to use as a new option trader is to trade limit orders. If you are attempting to put on the position as quickly as possible, simply put a limit buy at the ask or a limit sell at the bid. This way you will get filled at what effectively is the market, but it won’t allow any shenanigans from the market makers.

If you like a trade but are in no rush to get filled, then simply put a limit order at the mid price. This is the halfway point between the bid/ask spread. If you are really sneaky, you can try to get a little extra advantage by putting your order just below or above  the mid, depending if you are buying or selling. Sometimes you will get filled, but sometimes the market makers will step in front of your order, so the odds of getting filled will be a little lower.

This becomes a little more complex with trading option spreads. Because spreads utilize multiple option contracts, you will have to deal with multiple bid/ask spreads. Using market orders on spread trades causes the position to suffer twice as much as each individual option will be at an initial drawdown due to the order type.

When your trading becomes more agile and more advanced, you can then start to trade like a market maker, placing orders at the bid or ask, providing liquidity to the market and working a position around the spread for the best fill possible on a position.

The Exception

There are times in which market orders are justified. If a market is very liquid like the $SPY or $AAPL, then it may make sense to use market orders. Furthermore, if a market is moving fast and your position is on its way to getting stopped out, it may make sense to liquidate with extra slippage to avoid further losses.

Risk management in options trading also has a liquidity component. If it’s tough to exit your position, you will be more at risk than you originally thought. This is why for new option traders I highly recommend sticking with the most liquid options. First start trading individual indexes like $DIA, $IWM, and $QQQ, then branch out into individual names with super liquid options.

The CBOE has a great list of stocks with “clean” options at the Penny Pilot Program. This program was an initiative by the SEC to tighten up the spreads on option boards to help provide further liquidity in the options market. Download the current list [csv] to help with starting your option trading watchlist.

In Next Week’s Lesson…

You will learn the most important trading dates to watch for and how options trade completely differently than the underlying stock during these days.

If you want to be kept up to date with the Bootcamp, as well as get a video on option trading and psychology, become an IWO Insider today!

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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