I spent a frustrating few weeks in late December. Outside commitments kept me from entering my usual monthly options trade. I planned to use the time to run a few speculative trades in small lots. I found several that interested me and most proved successful. Unfortunately, I was watching from the sidelines rather than participating in the trades.
Here's one, a trade I considered entering when the mid-price of the spread was $1.60. I locked in a simulated trade at $1.63, to include possible slippage when entering the trade. The cost would have been $1.63/contract*2 contracts*100 multiplier + $1.25 commission/contract*8 contracts for entry and exit = $326 + $10 = $336. Later that same day, I took the following snapshot of the Think-or-Swim Analyze page showing that simulated trade.
Bearish TWC JAN 15 155/150 Put Spread at Close of Trading on December 31, from Think-or-Swim:
As can be seen in the price slice at the then-current price, $152.06, the profit was $131.99 (minus that $10.00 in two-way commissions). That's a (121.99/336.00)*100 percent = 36.31 percent profit for a day's work. Granted, $121.99 wasn't a huge earnings for a day, but my intention was to use these speculative trades to keep up my skills in picking out viable short-term trades since those are no longer my primary trading vehicle. I do this from time to time to keep my skills up to date. I picked out several trades like this one but watched them all without ever entering one. Why wouldn't I enter the small identified trades, especially since the ratio of possible profits to maximum losses were fairly evenly balanced, as I'd intended when I searched for them? Not much money was at stake, as least as compared to what I routinely put at stake in my monthly trades.
I had used chart and volume studies to identify the trades. I love technical analysis, but if you're using technical analysis alone to choose trades, you might want to think about that again. By definition, you might be screening for certain technical characteristics without knowing much about the underlying. Although I used a further qualifier, volume patterns, that still didn't mean I'd done quite enough research. That "think about it again" caution is the focus of this article.
What was the non-technical aspect of these trades that kept me on the sidelines? In the case detailed above, it was a look at the option chain, a concern I've mentioned in previous articles. Although the figures indicated decent open interest in both strikes I was considering, the 155 put featured a volume of exactly 2 at the time I was looking at the trade, well after the open, and the 150, amazingly since it was a round number, had a volume of zero. Zip. Nada.
I'm not in favor of taking a flight from my office just to travel to the trading floor to look up someone who will (or will not) dicker with me over the price of my options. Even if I could have gotten a fill somewhere near the mid-price or mark, there was never any guarantee that I could get out near that price. The low volume in all the options in this underlying for that particular expiration period also meant that I might need to leg out of the spread even if I could get into it in a single spread order. With a difference between the bid and the ask of the spread itself at about $1.15, there was a lot of room for slippage in exiting the trade, even if I stood firm on the entry. And that extra three cents I'd added for slippage when I'd priced the simulated trade? With volume like that, there's no guarantee that three cents would have been enough.
Another non-technical consideration I like to check is the short float. Investopedia's definition of "short float" is "the number of shorted shares divided by the number of shares outstanding." A stock with a high short float percentage can prove particularly dangerous for traders. Of course, the high short float percentage expresses a lack of confidence in the underlying's outlook or future price performance. Naysayers have piled on, shorting the stock as they wait for prices to descend. And sometimes, the shorts are greatly rewarded.
One Stock with a Short Float over 30 Percent, According to FINVIZ on 12/31/14, Graph by TOS:
But what do shorts do when they've made a lot of money, but they're getting nervous about all those profits, and there's the least bit of good news or even not-as-bad-as-expected news? They get out of their trades. And how do they do that? They buy. They buy the underlying stock, and then their compatriot shorts who were holding on a little longer decide they better get out, too, and then . . . well, you get the idea. They buy, buy, buy. Sometimes the gains are quite explosive on huge volume. The volatility can be especially harmful in a stock that's got a relatively low average daily volume.
Explosive Gains in a Stock with a High-Percentage Short Float, Graph by TOS:
The chronology may look confusing due to the positioning of my comments. The volume exploded when shorts bought-to-cover and then died back. Option traders in bearish positions might reason at the time of that high-volume short-covering rally that the stock would sink again after the shorts quit buying, easing the pain in their positions if not actually producing a profit. That's a dangerous assumption. Sometimes after that huge-volume short-covering rush, real buyers join in.
Daily Chart of AMAG:
This AMAG graph was snapped on 12/31/14, when I first roughed out this article. By 1/9/15, AMAG's price had eased slightly, closing at $42.44, but that was only after a big jump up to $47.75 in between the two dates. That jump to $47.75 would have been painful for shorts. Any shorts that had been in the stock back at that high-volume push through the $28-30 region had never gotten any relief. I want to clarify that I don't know the short-float history for AMAG back at that time. Finviz currently calculates its short-float at over 30 percent, but it may have been higher or lower at the time of that high-volume powering through the $28-30 region.
The point? If you're a technical trader, as many option traders are, remember to think beyond the technicals if you're trading a new trade or a new vehicle. That's true even in small lots with little money at stake. I might not have suffered greatly if I'd lost that money I could have invested in a TWC trade and I'm well aware of the occasional need to pay my "tuition money" in new trades. However, why should I willingly throw away money on a trade I can easily determine is too risky for my trading portfolio?
Other research I performed was checking on the earnings date (which turned out to be after the expiration of the options I was considering) and any other event dates. I hope your new year has started off productively. Here's to happy trading and a happy life, too, in 2015!