I’m sure you think of option traders and long-term mutual fund investors as being at the opposite ends of the trading spectrum — and they are. But option traders can actually learn a great deal from long-term mutual fund investors.
Because they invest for the long term, mutual fund investors understand the importance of fees.
John Bogle, founder of The Vanguard Group, popularized the low-cost index fund to overcome what he calls “the tyranny of compounding costs.” He even provided a road map to top performance for his competitors, explaining: “The shortest route to top quartile performance is to be in the bottom quartile of expenses.”
Today, I want explain how earning a few extra pennies on a trade can improve your returns.
I recently discussed how a relationship known as put-call parity ensures we can get fair prices for execution of option trades. Based on the math, we know that most options will be trading near their fair price. But when we look at a current price quote we see at least three pricing numbers for the option — the “last” price, the “bid” price and the “ask” price.
Many investors look at the last trade, but that is actually the least meaningful part of a price quote for options traders. That’s because the last trade might have been completed hours or even days before.
Instead, the most important parts of the quote are actually the current bid and ask prices. These are usually just a few cents different than the option’s fair value. The bid will almost always be a few cents below fair value while the ask is usually a few cents above fair value.
By definition, the bid is the price that someone is willing to pay right now to buy the option, and the ask is the price someone will accept to sell the option.
My preferred options strategy is selling options for income, particularly selling put options. There are two main benefits to this strategy: 1. I get to collect income upfront without dishing out any money to buy shares; and 2. I get the opportunity to buy shares if they fall below a level I deem a favorable entry price.
I have used this strategy to close 85 straight winning trades with an average annualized gain of 53%. To help traders understand exactly how this strategy works, I have put together a free step-by-step guide. You can access it here.
Getting back to options pricing, in technical terms, the bid price is offered by a liquidity provider. We are liquidity takers in the market.
When we open a trade with a “sell to open” order, we need a buyer to take the other side of our trade. We know there will be a buyer because potential buyers have placed bid prices into the market. On a “sell to open” order, we should expect to receive the bid price from the buyer of our option.
The difference between the bid and ask can be $0.05 or more and is known as the “spread.” The spread is usually considered to be another cost associated with trading. One way to decrease that expense is to enter our trade using a limit order, which lets us specify the price we’d like to sell our option for. This makes us a liquidity provider.
By setting a price for our “sell to open” order that is a little better than the current bid, we’ll still almost certainly be able to enter our trade and will also snag a few extra cents on each trade. That could increase our total return by more than 1% a year, all by simply using limit orders instead of market orders.
For example, I recently recommended my Income Trader readers sell a $55 strike put on a media company. At the time, the puts were trading with a bid of $0.55 and an ask of $0.60. If we opened the trade with a market order, we should expect to sell the put at $0.55, the bid price. But instead of using a market order, we could open the trade with a limit order that specifies that the lowest price we’ll accept for the trade is $0.58. Because of the way options trade, we are still very likely to get filled at that price, and we’ll increase our income by $3 per contract (each contract controls 100 shares).
The required margin deposit (i.e., the amount your broker makes you set aside as a “down payment” in case you are required to purchase shares) on that particular contract was $1,100, so the extra $3 per contract amounts to an additional 0.27% profit. Since the trade had about 10 weeks until expiration, we could theoretically repeat the trade about five times a year, thereby increasing our income by 1.5% annually.
I realize $3 per contract doesn’t sound like much, but adding more than 1% a year to your returns with no extra work is a no brainer. I recommend using a limit order between the bid and ask prices to maximize the return of every option you sell to improve your returns.
Selling options is an incredibly lucrative strategy. In fact, Brad C. from Memphis, Tenn., said he made over $1 million last year following my recommendations. If you’d like to learn more about how put selling works or get my trades sent directly to your inbox each week, follow this link.