Identifying trends and selecting the right options spread and timeframe for your trades is crucial to determine whether your trade produces a profit or a loss.
Entire books can be written on choosing the correct timeframe for options spread trading. However, I will present in his article just the basic ideas and expand with more specifics in future articles as needed.
Most option spread trades will use time decay to the advantage of the trade. For this reason, the time horizons for option spread trades are generally much narrower than either long-side or short-side-only option trades.
Many of my metal markets options had durations of months before options expiration. I was taking long or short positions because I knew the seasonal variations and was not always spread trading. Time decay generally worked against my trades.
I chose long- or short-side-only trades in some of these markets because I had very clear readings on the direction of the market for the period that I was considering. Essentially, I elected to trade only long or short positions because I had a high confidence in my market analysis.
However, with spread trading you will be dealing with trades that that have a much shorter duration. Many of the trades will only allow for near-term month expiration, or the month after the near-term month.
Specific vehicle for your options trade
For now, let us assume that we are not going to engage in cross-market spreads, inter-commodity spreads, or inter-sector spreads. Once you decide on the general market and the specific sector you want to trade, you must choose the specific vehicle or security for your options trade. By choosing a specific vehicle, you want to make sure that there is enough activity for your order to get in and out of your option trade with minimum slippage.
Slippage is when you place an order to buy or sell at a certain target price but the order cannot be filled at that specific target because the market does not have sufficient volume to fill the order. Slippage also can occur if your broker’s order processing system is inefficient. If there is an available market, most brokers will ensure you that they will fill your orders almost instantly.
When I engage in an options transaction, one of the first things I consider is the volume of trades on that option. Below is an example of options for Alphabet, Inc. (NYSE: GOOG).
The lesson here is to go straight to the options with higher volumes and to avoid low volume options. There is the possibility that you will be doing what is known as crowding an options trade. You are not choosing these options just because they have sufficient volume and are popular options to buy or sell. You will select these options because they meet all your criteria, including the volume and open-interest criteria.
As discussed in an earlier article, part of the criteria involves determining whether you are trading with or against the trend. Therefore, you should not choose an option that is going against your trading plan just because that option happens to have a significant volume.
In the case of a November put for Alphabet, Inc., several strike prices have sufficient volume. There are only two strike prices — the $945 strike price and the $950 strike price — that are clearly insufficiently traded and anyone new to options trading should stay away.
To summarize, you should choose options with sufficient volume and open interest for the sector you want to trade. While this seems simple and obvious, you can tell that there are option traders on Alphabet, Inc. options right now who are stuck taking whatever the dealer can find for them when they decide they want to get out of their option trade. The reason for this is that they ignored some simple and basic simple rules. You should enter option trades in sectors where there is sufficient volume to buy or sell virtually instantly.
Because many factors are involved in executing profitable trades, it is important to keep the decision-making process for each of the factors as simple as possible. As indicated earlier, you can use time decay to your advantage. The time frames for option spread trades will be much narrower than when you are trading simple long and short options and you will need to make quick decisions to take advantage of the market. If you stick to the basics and simplify your decision-making process, you will be able to choose and execute your trades quickly.
In a future installment of this series on option spread trading, I will discuss ways to pick the best options spread strategy for each market type
Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.