I recently released a new option trade where the credit for the trade was 1.75 per option spread. I then got the following email from a member and I thought I would share it and my response to help others that may have the same question
Just going thro. this new RUT trade. The credit on this trade (0.55) is far less than want u wrote(1.75). If this is not a typo from ur end, will it be still profitable to go for it at. 0.55.?
Here was my response:
It was not a typo. I placed this trade 50 days from expiration which is a lot of time, plus there are two sides, the calls and the puts. .55 might be acceptable if you were doing only one side – either call or put but not both.
You are not getting good prices. Even if I do the trade right now, I still get 1.75, actually it’s 1.77. Perhaps you need to open an account with an option friendly broker.
again, you are getting killed on your prices. When you enter your orders enter a limit order and put the prices in the middle of the bid and ask.
So if it is 1.00 .50 you would enter a price of .75
Does that make sense?
I do make mistakes and typos. But to go from 1.75 to .55 would be a colossal mistake. I have been thinking about writing a post called Option Friendly Brokers. Many of my members are using brokers that get them killed on pricing.
Option trading 101
When entering a trade, either a stock or options trade, you never want to pay the Ask or the Bid. You want to place a limit order and choose a price that is as close to the middle in between the Ask and Bid as you can get. The more liquid the item you are trading, the better your chances of getting the mid price.
This does get complicated with complex option strategies like the iron condor which uses 4 different options at the same time. That’s where the option friendly broker comes in. My broker does not make me compute the mid prices. My broker just tells me what the mid price is and that gives me a target to get filled at.
If your broker is trying to get you to place trades at the Ask and Bid, your broker is costing you a lot of money. In technical terms this is called slippage: the amount away from the mid price. Slippage is way more dangerous to a trader than commissions. Many new traders choose a broker with the lowest commission rates. Wrong!
As you can see from the email, slippage is much more costly than commissions. It took a trade where I was getting 1.75 and dropped the credit to .55! Slippage could have cost this trader 1.20 per spread! That’s $120 in dollar terms.
The easiest way to avoid slippage is to get an option friendly broker. The second way is to calculate the mid for all your trades and try to get as close to the mid price as you can.
Got questions? Drop us a note in the comments section and please go check our previous blog posts for useful stock market option trading and options selling tips.