THE BID-ASK SPREAD

GOOD TRADES AT FAIR PRICES

Your first trade can be a frightening experience, regardless of what you are trading. Until that first trade is behind you, the education process has been theoretical -- with nothing at risk. Pulling the trigger on that first order changes the game. There are two new things in your life: the possibility of earning a profit and the possibility of incurring a loss.

The information in this article is designed to help you avoid getting ripped off.
FUNDAMENTAL TRUTH: The transaction price is very important to your long-term success. The one exception is for the long-term trader who tends to hold positions for years, if not decades. As an option trader, your holding period tends to be short (few days to a few months, and each transaction represents an opportunity to lose money (i.e., by paying too much).
WHAT A TRADER SEES
When ready to place an order, you see "the market" for the options That market consists of a bid price and an ask price. If you enter a "market order", then -- in theory:
When you are a buyer, you pay the lowest price that anyone is willing to collect when selling the option.
When you are a seller, you collect the highest price that anyone is willing to pay when buying the option.
However, it does not work that way in today's computerized marketplace. The broker's software is designed to find the lowest or highest "published price" for the option. Translation: The program is not designed to negotiate prices. It merely finds the best available price and executes your order. If someone is willing to sell at a lower price -- but does not advertise (i.e., publish) that price, then your market order cannot find that lower price and you will pay the lowest published ask.
For example, one market maker may publish a bid price of $1.20 and an ask price of $1.40. For this discussion, let's assume that this market maker represents both the highest current bid and the lowest current offer at the time your market order reaches the floor of the exchange. When that happens you will pay $1.40 when buying and collect $1.20 when selling.
Notice that it does not pay for this market maker to bid any higher (nor offer to sell at any lower price) because the computerized program is designed to pay his/her prices (unless another trader publishes (i.e., displays) a better price.

SAFELY INVESTING FOR THE LONG TERM

When markets decline, and especially when the decline is deep enough to frighten a substantial number of investors, put options become much-desired commodities and prices soar. This price change comes from an increase in the implied volatility.
The conservative, well-prepared, investor understands risk management and has some method in place that cushions his/her net worth against a stock market debacle.
Those investors never panic and buy/sell decisions are made on their merits, and never out of fear. When they want to own put options -- or adopt a different portfolio management technique -- they already own them as part of their ongoing strategy. There is no need to pay up for options just because unprepared investors (and speculators) drive prices higher.
I absolutely believe that stocks are the best game in town. I don’t think there is a better way for the average investor to grow their wealth. However, this is called investing and the price of admission is gut wrenching drawdowns and sometimes years and years with nothing to show for it. If you can accept that this is the way things work, you can be an enormously successful investor.
The majority of investors tend to remain 100% bullish at all times. That investment philosophy can be successful for people who understand how the market works. Such investors invest in risk management ideas that limit the size of any drawdown (i.e., they do not lose so much money that they feel a need to sell everything in a panic).
This allows them to remain invested and to participate in all bullish markets.

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USING POSITIVE THETA STRATEGIES WHEN BULLISH OR BEARISH

COLLECT  THETA AND EXPRESS A MARKET BIAS
MARKET-NEUTRAL STRATEGIES earn a profit when time passes and the "magic" of time decay (Theta) does its thing. Of course it is not as simple as opening a position and waiting for the profits to accumulate. There is always the possibility of a profit-destroying price change in the underlying stock or index.
Nevertheless, these strategies work well when the markets trade within a narrow price range. The beautiful characteristic of these versatile option strategies is that they can be used by the bullish or bearish investor as well as by the market-neutral trader.
LET'S EXAMINE THREE STRATEGIES.
CALENDAR SPREAD
ABCD is currently trading at $65 per share. Believing that the stock price will rally towards $70 as the December 18, 2015 options expiration date approaches, you buy an out-of-the-money calendar spread.
Traditionally, the calendar is used by traders who believe that the stock price will remain near $65 when a specified expiration date arrives.
But there is no reason why it cannot be used by traders who believe that the stock price will differ at expiration. One advantage of using the OTM calendar spread is that it is less expensive than an ATM (at the money) spread.
Example:
     Buy 6 ABCD Jan 15 '16 70 calls
     Sell 6 ABCD Dec 18 '16 70 calls
As times passes and the stock moves towards $70 per share, the position becomes more valuable and you earn a profit. That profit is maximized if the stock is almost exactly $70 per share on Dec 18, 2015. At that time (or earlier if you wisely do not attempt to earn the maximum theoretical profit) you close the position by selling the calendar spread. 
If the stock price does not conform to your expectations, then the spread will lose value as the December calls expire (and become worthless).
You can keep your Jan calls, hoping for a miracle, but it is often wise to sell the call and recover some of the cost of buying the spread.
NOTE: One factor that affects profitability is volatility. When implied volatility is relatively high, the profits are even larger than anticipated. When implied volatility is low, the profits are reduced.

DOES THE REWARD JUSTIFY THE RISK?

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

RISK MANAGEMENT FOR THE NEWER TRADER

BUYING OPTIONS AND PREDICTING MARKET DIRECTION
Newer option traders tend to adopt the strategy of buying calls when they are bullish and puts when they are bearish.
It is very easy to buy some options based on your market savvy. In other words, you -- like the majority of new investors -- probably believe that the trade will be profitable because you believe that the stock price will behave as you predict.
That is based on the belief that you have a talent for stock picking and timing the market.
Despite a ton of data to the contrary (Numerous available data sources illustrate that individual investors perform far worse than the market averages when making buy/sell decisions) most still believe that they are not average investors and have the ability to beat the market.
RISK VS. REWARD
Those beliefs often lead to unwise investment decisions. That brings up the topic: How much money can you afford to risk when making investment decisions based on your ability to know what the future holds?
The more difficult questions are:
·         Can you estimate the probability of earning a profit from a given trade?
·         How does the potential profit compare with the money at risk?
EXAMPLE
The inexperienced option trader may look at a RS 40 stock, decide that the price is heading higher and seeing that the two-month option with a RS45 strike price costs 'only' RS0.15 (that's RS15 per contract), decides to invest RS75 by buying 5 contracts.
ANALYSIS OF THE TRADE
The risk is only RS75, so at first glance this seems to be an acceptable trade. After all, the potential gain is theoretically unlimited and the maximum loss is just RS75.
However, that is not the whole story. This is a stock whose price fluctuations are tiny. Translation: this is a non-volatile stock. In fact, over the past couple of years, the average daily price change is only 5-cents per share. The probability that the price can rally far enough in 45 trading days to turn this investment profitable is less than 1%. In other words, the likelihood of earning any profit from this trade is dismal and the most likely outcome is a 100% loss.

YOUR FIRST OPTION STRATEGY. SHOULD IT BE BUYING OPTIONS?

CATEGORY: FOR THE OPTION NEWBIE

It seems natural to buy options. After all, isn't that why they exist? The answer is no. Options were created to shift risk from the risk avoider to the risk taker. They were not created as a tool for speculators, although speculators play an important role in the options world.
It is important to understand that all investing has a certain resemblance to gambling. However, investors gamble only when they make trades based on too little information or when the trades are based on ‘hoping’ that something specific will come to pass.
I discourage gambling with options and I hope to encourage you to adopt a similar attitude. Nevertheless, it is convenient to use gambling vernacular when discussing certain aspects of trading.
TRADING OPTIONS IS QUITE DIFFERENT than trading stocks. When buying a call option, the investor (or trader) Is making a bet that the underlying asset (usually a stock, but it may also be an ETF (exchange-traded fund), index, currency, commodity etc.
Will move higher or lower before the option expires. Under most circumstances, it is a bad bet.
These are the primary reasons:
DIRECTION. Although most investors/traders believe they have the skill to know when the market will move higher or lower in the future, there is a ton of evidence that says just the opposite. For example, studies show that most individual investors under-perform the market averages, year after year. This is more a result of buying and selling at the wrong time, rather than of owning the wrong stocks. No matter the reason, the average active investor does worse, on average, than those who tend to buy and hold. Much of the poor results can be blamed on buying when everyone’ is bullish (near the market top) and selling when traders dump stocks in a panic (near the bottom).
Another study shows that most investors perform far worse than they believe they do. This seems strange, but perhaps this finding can be blamed on a poor memory. More than likely it is a result of traders remembering good results while tending to forget their worst trades.
If you believe you are a good stock picker and will get the direction right significantly more than half the time, then perhaps you can make money buying options.
However, there is much more to consider. See below.
Keep a written record of every buy/sell decision. This is part of your trade plan. Do not fudge the results because you would only be hurting yourself. If you have a proven (in writing) track record of being able to earn far more than your trading expenses, then buying options may work for you.

OPTIONS FOR BUSY INVESTORS

Both investors and traders can use options.
The generally accepted difference between investors and traders is that investors make portfolio changes far less often and that they have the time and patience to allow their investments to grow. In other words, investors are not interested in instant gratification whereas traders prefer to make a trade, collect a quick (a few minutes to perhaps a couple of weeks) profit and exit the position.
Traders seek stock-market profits by selling as soon as a profit target is met. They never get married to a position. Nor do they have loyalty to the company whose stock they own. They often ignore the nature of the company itself, relying on charts to make buy/sell decisions. Some traders own positions for as little as a few seconds, while others may wait as long as two months for a position to work.
There is also another major difference. Trading is a full-time job because there is a continuous need to monitor positions and to make important decisions. Investing is something that anyone can undertake. Don't misunderstand. It is not a simple process. Instead it requires that an investor finds the time to do the necessary work for making important decisions. Unless you want to pay someone to manage your portfolio by buying mutual funds (a poor choice), ETFs (a good choice) or hiring a financial advisor, the successful individual investor does his/her homework. 
Investors tend to hold positions for years, decades, or even an entire lifetime. As a consequence, they make few investment decisions.
Investor portfolios should be examined on a regular basis (at least yearly) with the goal of unloading stocks that no longer deserve a spot in the portfolio. Alas, that seldom happens and many buy and hold investors believe in holding forever.
Timing is not a big issue because paying a few cents more per share, has little effect on the long-term results.

PHILOSOPHY BEHIND WRITING COVERED CALLS

COVERED CALL WRITING is a popular strategy among individual investors. It has also attracted the attention of mutual fund and ETF managers and there are a number of funds that use covered call writing as part of their investment strategy. I would offer a short list, but I do not want to recommend that anyone use such funds. 
If you have the time and willingness to trade your own money (as millions of stock investors do), then writing covered calls is something to consider.
It is not a good investment choice for everyone. 
When writing covered calls, stock selection is the single most important factor in determining your success or failure. Yes, selecting which option to write plays a big role in your performance, but if you own stocks that under-perform the markets on a regular basis, then you cannot expect to earn much (if any) money.
WHO WOULD WRITE COVERED CALLS?
Covered all writing begins with stock ownership and this article is written for such stockholders. It presents the pros and cons of adopting covered call writing (CCW) as a small or substantial portion of your investment portfolio.
CCW is also used by investors who have no current position in the individual stock, but who would buy shares with the intention of writing options and collecting the premium.
WHY WOULD ANYONE WRITE COVERED CALLS?
As with any other trading decision you must compare the advantages and disadvantages of the strategy and then decide whether the risk vs. reward profile suits your investment goals.
WHAT DO YOU HAVE TO GAIN?
·         INCOME. By selling one call option for each 100 shares of stock that you own, you collect the option premium. That cash is yours to keep, no matter what happens in the future.

NEUTRAL STRATEGIES FOR THE NOVICE

Options are versatile investment tools. They can be used for both bullish and bearish strategies. But what separates options from all other investment tools is that they can also be used for neutral strategies. Those are appropriate when:
·         You do not have an opinion on market direction.
·         You believe that the markets will be relatively unchanged over the near term.
Let's discuss some of those strategies.
Note: This article is intended for the novice options trader. More experienced traders can find additional information by clicking the links below.
Market-Neutral Option Strategies
Important note: Unless you are a very experienced trader, always enter these orders as "spreads." A spread order tells your broker that
·         The order contains two or more different options (each option is a "leg")
·         The order requires that the broker fill each leg, and not just one. By  entering a spread order with two legs, you will never find that you bought or sold one of the legs.
If you don't know how to enter such orders, ask your broker's customer service department  how to enter an option spread order. 
Calendar Spread. The trader buys one option (call or put) and sells another option of the same type (i.e., call or put) with these restrictions:
·         The option bought expires after the option sold (i.e., it is "longer-dated")
·         The underlying asset is the same for both options.
·         The strike price is the same for each option.
The longer-dated option always costs more than the near-term option.
Thus, the calendar is a debit spread.
Fact: Shorter-term options decay (i.e., lose value) more quickly than longer term options. (See Theta)
Rationale for buying a calendar spread: When time passes and the stock price remains essentially unchanged, the spread gains value because the option that you bought loses (or gains) value more slowly than the option that was sold.
Therefore, the price of the spread (the difference between the price of the two individual options) increases. This spread is appropriate when you believe that the stock price will remain near its current level.
Risk:
·         If the stock price moves far away from the strike price, then the spread loses money because calendar spreads are worth more when the options are at the money.
·         When the stock price runs higher, the nearer-term option gains value more rapidly than the option that you own (this is due to gamma).