Option Trading Tip #3
My top 10 call and put option trading tips that I have learned, and that you MUST know before you start trading calls and puts.
Trading Options Tip #3:
Use the option chain to find the best priced option.
After you have looked at the stock chart (Option Tip #2) to get an idea of the trend line of the stock, then look at the option chain. Most stock quote pages will have a button that says "Option Chain" or simply "Options." When you look at an option chain you will see that it is a list of all of the calls and puts available on that stock. The option chain will typically be divided into two columns. The left column will be the call options and the right column will be the put options. The option chain will also show you the strike prices and the expiration dates of the call options and put options that are available for trading.
The first thing to note is the expiration date. Options used to be traded with a single monthly expiration date which was the third Friday of each month. In the last few years the option exchanges have started allowing weekly expiration options on the most active stocks. The point here is to make sure you know the exact expiration date of the options you are looking at.
Once you know the expiration date, take a look at the available strike prices. Note that some stocks have strike prices in increments of $1, some have strike prices in increments of $2.50, and most have $5.00 increments.
Next take a look at the volume column and note which contracts are the most actively traded. If there is lots of volume on a certain expiration month and strike price, then maybe you should be thinking of that option too! Definitely avoid the contracts that have little or no volume.
Finally, note the spread between the bid price and the ask price of the most heavily traded option contracts. If the bid/ask spread is 10 cents or less you are safe trading it. If the bid/ask spread is larger than 10 cents then there might be a liquidity problem and you should be careful trading these options. When you buy an option with a 15 cent bid/ask spread you are starting off with a 15 cent loss in the option (not to mention the commission)! Generally you want to avoid the calls and puts that are thinly traded and/or have high bid/ask spreads.
Start by finding the options with the most volume and ask yourself 'why is everyone else trading that contract?'. Those options might be a good place to start as it is sometimes easier to ride the coattails of the "smart money" than to blaze a new trail. If you have a streaming option chain (one that refreshes every second so you can see the immediate price movements) then you can get a feel for the buy and sell orders coming in and how liquid the contracts are. Try to watch the stock price movement as it bounces around 10 cents and see how much the bids and asks of the options are changing.
When you are just getting started trading options, it really helps to start with options on a stock like Apple or Google that has both volatility in the stock price and extreme liquidity in the options. Also notice that in the first 15 minutes and the last 15 minutes of the trading day (9:30 to 9:45am ET and 3:45 to 4:00pm ET) you will see lots of volatility. Likewise, you can almost see the traders go to lunch at noon as the markets and volumes seem to diminish and then pick up again after 1 pm ET.
Here are the top 10 option concepts you should understand before making your first real trade: