Tag Archives | selling straddles option questions answered ETF vs Index options bid/ask spreads wide markets

Ligntning round: Questions answered

Hello,

I hope you remember me. I wrote to you in June
and got advice as to what a “straddle” was and I have another
question. 

Say I buy a stock selling for $4 and sell to open, a covered call with a $5 strike and collect $1.80; and sell a naked put for $2.40.  Is my math correct
in that I would profit $.20 for buying it?  Basically refunding the cost of the stock to my account to
reinvest while at the same time, my maximum risk would only be $.80 (i.e.
$5.00-$1.80-$2.

RB

***

Yes, I remember your question.

If you sell the straddle and collect $4.20 – all I can say is that this is one volatile stock. 

Yes.  If the stock rallies and you are assigned an exercise notice on the
call option, you have a big profit.  Your net cost is negative 20 cents
(you are correct) and you sell the shares @ $5.  Net gain $520.

If the stock tumbles to zero, you are correct again in that you only lose $80
on the straddle.  But you did buy 100 shares, paying $400.  So that
cash is also lost.  Maximum loss at bankruptcy:  $480.


Hi Mark,

Why do you prefer trading RUT over other indices eg. QQQQ? (do you really trade RUT only?)


Thanks, Deb


Hi Deb,


It's not that I have a big preference for RUT, but I prefer to trade a bunch of different positions in a single underlying. By doing so, I find it much easier to manage position risk because there is only a single set of Greeks to follow – instead of a set of Greeks for each underlying.

I want to use cash-settled options, so chose an index.
I'd prefer to trade SPX, but find the markets too wide and it takes my broker too long to let me know about being filled on my orders.
RUT is more volatile than SPX, but at least it satisfies my other needs.


Mark,


Is it a bad idea to trade options when the bid/ask spread is wide? Should these options be avoided?

WW

It's true that you should prefer to trade options with tighter bid/ask spreads, but don't let the wide spreads bother you.  You can do a simple test to learn whether the these options are worth trading.

Ignore how wide the market is and focus on the midpoint between the bid and ask prices.  When buying, bid 5 or 10 cents over that mid-point.  Only go as far as 15 cents if you are anxious to make the purchase.

Over a couple of days and a few attempts to buy and sell options, you will discover whether the traders of these options are willing to bend, or if they stand firm and only trade at their prices.  When none of your bids or offers is taken (single orders or spreads), give it up and find a different underlying asset to trade.

It's not the wide markets that's the problem.  It's the true market – and you cannot discover what the real bids and offers are, until you try to locate them by entering an order.

473

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