Welcome back to a series I enjoy writing: the Morning Mailbag! This edition involves questions about option liquidity and credit spreads.
From Matt in Colorado:
I’ve been watching the TT shows and reviewing some of my class notes and lab notes. When everyone talks about option liquidity, I think the guidelines get a bit fuzzy:
- Bid/Ask spread:I’ve been using the following guideline: 10% or less as defined by the following formula: (ask-bid)/ask. Is this right?I notice that as you move further OTM, the bid/ask usually widens; I assume that means we’ll have to examine bid/ask for every strike we consider, not just the ones ATM or close to it?
- Volume: I know we look at volume and want to see some action, but it resets daily; so I’m okay with watching that. I assume that if I consistently see “0” during the day then that particular option isn’t liquid?
- Open Interest: I have started to notice that some stocks have strikes with very little open interest, but other strikes have a lot of open interest (i.e., FLR). So, the size of my spread may be determined by which strikes offer sufficient open interest? In my current state of ignorance, I would guess that: entering a vertical spread with one strike good on open interest and the other strike not-so-good, will cause crappy fills if I want to get out of the spread early (buy-back at 5 cents / hit stop loss)?
Any other notes/guidelines on liquidity are welcome.
Hope you are enjoying your summer!1) Do you use alerts? Do you have a rule for where to place them?2) Right now I use my regular trading account until I use up my funds and then switch to my IRA. Should I have a better strategy than that?
3) Do you have advice for your students who want to retire from employment? Should I have a certain number of years of experience? Certain number of trades? Make a certain amount of income?
4) I see that there can be a loss for a position at first based on the prices I choose to pay, even if the parameters are all correct, and over time the loss turns to profit. For example, if the stock is above the strike prices for a bull put spread from the very beginning, there can still be a loss at first. A) Is that due to theta? Is that true for all strategies (whether positive or negative theta)? B) Is there a way to tell before entering the trade how much the loss at the beginning will be? Should I care?
5) Why does the risk graph for a bull put spread not look like a combination of a risk graph for a long put and a short put?
6) Do you have a net credit rule for the iron condor?
Thank you very much and have a great day!
Julie in Alaska
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