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Best Practices

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Liquidity & Strike Selection

Best Practices

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

The most important metric to look at when placing a trade is liquidity. Trading liquid products allows you to enter and exit the trades close to the mid price that you choose. Liquidity also plays a large part in which strikes we choose to trade.

Today, Tom Sosnoff is joined by Tom "TP" Preston as the guys discuss liquidity and strike selection. Here they explain why liquidity is so important when trading options. The guys also explain which strikes to choose, based on open interest and option volume, when the underlying as a whole isn't as liquid as they would like!

Tom P: Tom Sosnoff, we are back.
Tom S: Oh, There is a Rat in the Kitchen and I don't want to know. I'm Tom Sosnoff.
Tom P: What, there is a rat in the kitchen, what?
Tom S: The song, There is a Rat in the Kitchen.
Tom P: Oh, I thought-
Tom S: We play two songs on usually the start of the week.
Tom P: I didn't know it was what was called.
Tom S: I don't like Mondays but unfortunately it's not.
Tom P: Yeah, it's Tuesday now.
Tom S: Yeah, but it's Tuesday, but that is a Rat in the Kitchen.
Tom P: It's Tuesday.
Tom S: I know.
Tom P: Time for Best Practices.
Tom S: So just a couple things before we get into Best Practices. So crude oil is actually sold off nicely. We sold some calls on Friday morning and now, sometimes it takes ... all I'm trying to do is be transparent enough so you can kind of see through-
Tom P: You trade in the Aprils.
Tom S: Yeah, we trade in the Aprils; we sold some double calls which are the 55s.
Tom P: The 55 calls.
Tom S: At around like 250 on Friday, and then crude oil is going straight up, we didn't do anything. And now they're back down to like 220'ish. So now we're trying to sell some 48.5 puts or 49 puts and against those calls and then we'll have on our, you know. And I think one of the keys, the only reason I bring this up is one of the keys is you've got to stay ... if you're able to stay relatively small.
Tom P: The 48.5s.
Tom S: The 48.5s is I think what I'm offering.
Tom P: $1.43 right now.
Tom S: Yeah ... no, in April?
Tom P: Yeah.
Tom S: No it seems far-
Tom P: Yeah, that's what I was thinking, it seemed ... I [crosstalk 0:01:30]
Tom S: I'm offering them in $1.60, they're trading at $1.55.
Tom P: Um-huh.
Tom S: But if we get filled, that's just kind of a ... just an idea of how to, you know, sometimes select some premium in there.
Tom P: Yeah.
Tom S: Just sell them to strengthen by ... because so many people email us all the time and say, "How do you know that some are?" "You don't." "How do you know that some are?" "You don't." You just ... you sell them to strength, and then you sell them to strength again on ... sell them to strengthen the way up, you sell them to strengthen the way down, and that's-
Tom P: That's right. You don't-
Tom S: There is no other way to trade.
Tom P: You don't know other than saying, all right, crude oil is ... April crude is down 58 cents. They're down, that's weakness, also puts. They're up strong, also calls.
Tom S: That's exactly it, and very few people understand that. I may not get filled on these, but if I ... I'm fine if I don't, because I'm just short some call premium, but ... which is the same thing as just, you know, it's short delta, but it's something short of premium.
Tom P: Let me ask you this. Why is crude oil down 58 cents?
Tom S: I've no idea.
Tom P: You've no idea.
Tom S: Of course not.
Tom P: You don't care.
Tom S: No, I don't.
Tom P: You don't care. All you look at is its down, the premium is there, [inaudible 0:02:23] ... you're going to trade.
Tom S: Yeah. So I will look to sell NASDAQ futures if ... because we bought a bunch last night ... in the 60-handle, now they're in the 80s. So if they get up around 85, I think we're offering some, let me just check real fast. Yeah, we're offering some at around 88, but I'll go down in price once the market opens. If we have a chance to sell NASDAQ futures, we will today. If we have a chance to sell S&P futures, we will ... wrapped up around record highs, and we'll see what happens. I'm going to stay short of bonds, they're down to 145-10, they've been all over the place. They've had ... the bonds had great volatility here. So -
Tom P: Yeah, bonds have behaved ... had more volatility these past few weeks than anything.
Tom S: I just think, I guess ... I want the takeaway from this discussion to be that you see, hey, we don't know and we don't care, because I still get all these emails about, you know, Tom, you've got to look at relative strength, you've got to look at support ... no, you really don't, you're just trading, you're just trading. You're selling it to strength, you may be covering it to weakness, and you may reload again into strength the other way, whatever it is, and you just have to keep the machine going.
Tom P: The reason we get those questions is people have been listening to ... how old they are, for the past 30 years of everything that says all the sort of stuffs is important, that's what you need to know, and you don't.
Tom S: Yeah.
Tom P: You don't.
Tom S: Yeah, I'm going to have ... I'm going to have a really interesting discussion later tonight with Dylan, and you'll love this discussion TP, we're going to talk about everything from robot advisors on down. And the reason we're talking about is I'm going to tell you why I think every trend that we currently see in the industry today from robot advisors to free stock trading to robot advisors to even the SEC ... and essentially even the SEC and Congress starting to mandate more fiduciary responsibility to brokers and how all of that in my mind is negative; not positive, it's all negative, because we're not ... because we're not addressing the real problem, which is knowhow and domain skill. All we're doing is slapping on cheaper rates and a bad fix. And in order to truly fix something long term you have to go to a completely different space.
Tom P: You have to change the behavior.
Tom S: That's right.
Tom P: You have to change the behavior.
Tom S: You have to change behaviors ... you have to change the foundational behavior, and you can't do that by just lower rates. Sure, is lowering rates better than ripping everybody off, of course it is, but that's an obvious.
Tom P: No, but whatever is cheaper you get more of. If it attracts people to do the wrong thing, then it was a mistake.
Tom S: There is ... Tony used this saying all time, it's ... you can't afford free, and you can't afford free when it comes to finance, because what you're doing is you're not ... you just don't understand where the fees are coming from then.
Tom P: That's right.
Tom S: It's just ... it's all they're doing-
Tom P: Because nobody is doing it for free.
Tom S: That's right. All they're doing is moving the fees from the front end to the back end. And that's not the solution.
Tom P: That will be a good discussion, that will be good.
Tom S: Yeah, it's ... so I can't wait, that's 4:30 this afternoon, and lots more to come on that.
Tom P: 4:30 live with Dylan, right, you're doing it live?
Tom S: Yeah.
Tom P: Excellent.
Tom S: That's the fill, you see, got it off. Now we're short the 49 puts and the 55 calls, which is exactly ... we're at 52 right now, so we're right in between, and you can see ... by the way, if you are interested in skew, one of the lead things ... with crude oil trading right at 52, on the-
Tom P: You sold those previous ... sold the 49 puts at what, $1.60?
Tom S: Yes. So if you look at the 49 puts at $1.60 and you look at the calls, where are they, about 2.15?
Tom P: Yes.
Tom S: The 55 calls, and they're equidistant, right?
Tom P: No, the 55s, they rally 2.07, 2.08.
Tom S: Oh, at 2.07.
Tom P: Yeah.
Tom S: So a put is 1.60 and the call is 2.07, and they're exactly the same distance away.
Tom P: That's right.
Tom S: So we call that kind of ... that is-
Tom P: That's skew in action.
Tom S: That is very typical for commodity skew when the market perceives the risks to be ... in this case to the upside.
Tom P: That's right, that's right. Physical commodity, and particularly with crude oil down at this price.
Tom S: Now, when you look at options ... when you look at index skews on options, on listed options, you're going to see the puts rich and the calls cheap, because there is always calls for sale.
Tom P: Stocks generally crash lower, they tend not to crash higher.
Tom S: That's right.
Tom P: Physical commodities crash higher.
Tom S: When people think crude oil is cheap, the risk of the "crashes to the upside," and I love people talking about $20 crude oil right now, because you're going to get ... because they're going to get slapped. But anyway, I want to sell some crude oil premium, we finally got it off. So ... we've got a nice little couple days here going on. So let's try to keep the game going. Liquidity and Strike Selection, Best Practices, you're ready for this one TP?
Tom P: I'm ready for it.
Tom S: He's Tom Preston sitting in for Tony Battista today, and I'm Tom Sosnoff and welcome to Tastytrade. This is our first day with our new hands or our new schedule, so to speak.
Tom P: Yeah, we had Tim Knight in the morning.
Tom S: Tim Knight began the show and we'll get used to it, it will take us a couple days but we'll get used to it. So far the feedback on Tim's session was nice ... nice way to start the day and so I appreciate all that stuff. And let's just get cracking; we've got a monster for you today, lots of good stuff. So liquidity and strike selection. We probably get at least a few dozen emails a day from new listeners that are curious, because the industry has always, this has been an industry that has always said, "Hey TP, you got an idea? You got a directional idea, then make your bet."
Tom P: That's right.
Tom S: Hey, do you love this company? I always used to say, if you'd like to take your credit card out for this specific company, then sure [inaudible 0:07:03] the stock, but how ridiculous is that now, does it sound today? You know, they're like, people always say, how do you make your decision on what you're going to trade, you know, what stock you're going to trade, what underlying you're going to trade, and then people still to this day go , "Oh, you've got to do your fundamental research and you've got to make sure" ... and Tim Knight will tell you, "Well, you've got to do your technical research and you've got to make sure." We will tell you something really simple. It's all about liquidity. Liquidity rules. There is no such thing-
Tom P: Liquidity trumps all.
Tom S: Everything.
Tom P: Everything.
Tom S: If it's not liquid, the markets are not tight, then there is no efficiency, and then you can't make money.
Tom P: No directional opinion, no idea you have is so good that it can withstand poor liquidity, or lousy execution.
Tom S: Unless you are the seller of the illiquid product.
Tom P: That's right.
Tom S: Only the seller of illiquid products ever makes any money. The buyer of illiquidity cannot make money. There is no mathematical model other than that ... whatever it is, 1%,2%,3%,4% of the time. Every other math model says, if you are a buyer of illiquidity, you cannot make money. So why is your stocks being different? You trade what's liquid, it doesn't matter what else there is.
Tom P: It doesn't matter what the story is.
Tom S: Doesn't matter.
Tom P: Doesn't matter what the price is?
Tom S: Doesn't matter.
Tom P: It doesn't really matter what the volatility is because you adjust your strategy for that.
Tom S: Yeah.
Tom P: Liquidity starts everything.
Tom S: You know, there is this company is going to cure cancer, this company is going to create electric cars, this company is going to change the world, you know, solarwise, this company over there has got the best technology, if they're not liquid, it doesn't make a damn bit of difference.
Tom P: That's right.
Tom S: So a topic that viewers often ask us about is strike selection. More specifically, how do we determine which strikes to use for strategies. Well, are they determined by probabilities, price, or some other factor? Now, there's going to be a little bit of a difference of opinion here between some of the things that our research team did and some of the things that we believe. Because-
Tom P: That's okay.
Tom S: That's fine, because we believe that liquidity trumps all. Now, define liquidity? So if you have a stock that has a lot of shares traded, that's liquid. If you have a stock that has ... that's easy to borrow, that's liquid. If you have a stock that let's just say, you know, 10 options traded at 1 strike, but a 1,000 options traded at another strike, and then 30 options traded at the next strike. So 10, 1,000 and 30, that's liquid, it doesn't matter we strike. Because ultimately, you know, as long as-
Tom P: Market makers don't make markets in one strike.
Tom S: It's a computer.
Tom P: That's right, computers don't care.
Tom S: How do you determine strike selection? Well, but ... the difference here is that strike selection by itself is important, because what you want to make sure is you want to make sure that throughout your whole process of trading, you're mechanical. So the first place to start with selecting strikes is determine your preferred probabilities. This is exactly right. Determine, "Hey, you know what, what is the statistical chance of success that I want to live with?"
Now, we get emails ... again, we get tons of emails. We get emails everyday from people that go, you know what, I tried to be right 80% of the time and I was right 87% of the time. I haven't learned how to make any money yet, I'm still down money, I haven't learned how to make money, but I can see that the statistical chance of success if playing out. So I have to figure out what I'm doing wrong in order to get better, because I'm at least hitting ... that's the first step. Because 99% of the people don't realize, if you just predetermined your preferred probability, you can reach that.
Tom P: Yes.
Tom S: It's just a math model. There's no other ... it's just a math model.
Tom P: And people have to ... before the profits and all, before you start worrying about that, you have to see that the numbers actually play out in real life.
Tom S: So on Dough, one of the things that we do is we show you the 1 and 2 standard deviation lines, on both the table layout and on the plot layout.
Tom P: That's right.
Tom S: So you can look at the Dough curve or this, and we share the 1 and 2 standard deviation lines. The reason we do that is because we want you to be ... we want to set you up and put you in a position where you understand statistically, you know, what you're going for.
Tom P: We want to draw your eyes to the ... to a good starting point.
Tom S: Right.
Tom P: So is it always [inaudible 0:11:06] up to 1 and 2 standard deviations, of course not, you adjust around and it's a balance, but the point is that's a good place to start. All right.
Tom S: Once probabilities are determined, it is critical to tweak our strikes based on liquidity if your underlying is not extremely liquid. This is correct, now, there is different ... occasionally, you will find somebody will be like, this is not ... this is not that strong underlying for me. So of all the strikes there, remember you are competing against a computer, but just think about this. If you were trading with me Tom, I am more likely to make a market, better market on strikes that I have less risk on.
Tom P: Yes.
Tom S: So if Tom is the trader, and I am the server, or I am the person who is programming the server or whatever it is, I am more likely to be ... make a tighter market on his request for a market if I have less risk, that I have to worry about hedging off.
Tom P: That's right.
Tom S: So if I came ... so if he's buying an out of the money option, or selling an out of the money option, okay, it's easier for me, I have less deltas to hedge.
Tom P: That's right.
Tom S: Same with spreads and things like that.
Tom P: And to say that specifically, you can make a ... a mistake in your hedge doesn't hurt you as badly.
Tom S: Yeah, sure.
Tom P: In other words, if you buy those calls for me or you buy those puts for me, and you need to sell 3 shares of stock, or 300 share of stock, whatever, instead of 10,000 shares of stock, if you miss your stock by a penny or two pennies, it hurts less in that far out of the money option.
Tom S: When looking at bid/asks, how do you determine liquidity? Well, while looking at bid/ask spreads, we'll often give you a good idea of liquidity. It's also a good practice to check volume and open interest, of course. In fact, one of the defaults we have on our platform is to always have volume up there. I'm not ... I don't look at open interest probably as much as other people do, but I always check volume. Options with high volume and decent open interests will generally have tight bid/ask spreads; okay, that's just common sense.
Tom P: Yes.
Tom S: All right. And you know it's the same thing if you go to buy a car that's $200,000 car, you're not going to get a very tight market on the resale or on the purchase, but if you're going to buy a car that's you know, $19,000, you're going to have a pretty tight market of a couple hundred dollars, as opposed to tens of thousands.
Tom P: That's right.
Tom S: So these we looked at were March GoPro options, so we looked at kind of the viable strikes. As you can see, the open interest figures in the green and red boxes there, as well as the volume bars on the right hand side of the page. So one of the cool things is that, you know, obviously, we're just showing the different ways that Dough will display this, and you can go back and look at all this stuff. It's important to note that open interest is updated in the morning of each trading day while the volume is updated in real time.
Tom P: That's right. So not frequently, it's real time. As soon as the trade happens the volume increases but open interest is reported at the end of the day, so you see yesterday's open interest today.
Tom S: That's right. So as a result, we'll sometimes see options with low open interest but high volume, and that's because the next day you'll have the ... the open interest more reflected to so ... not confusing there.
Tom P: That's right.
Tom S: So in March AAPL options, you know, what are the most viable strikes. And so we kind of show you there. Remember how we talked about kind of the ... just the nearest out of the money options, and that 's the kind of perfect example you're going to see it, right there. I'll keep moving along so we get all this. We can also look at volume on the table page and we'll show that as well. So you can see right there, the volume is one of the choices in the dropdown menu.
Tom P: And this is a good tutorial on where to find the stuff that-
Tom S: Same thing is available on [Toss 14:26], the exact same thing. As we can see, in less liquid underlyings such as GoPro, we have to be more ... a little more selective in our strike selection. In extremely liquid stocks like AAPL, we have almost complete freedom to choose any of the strikes that you want. Again, it's all common sense, but we had this general default. For short options, nearest out of the money, you know, around the 30 or 35 delta, for long options, either at the money, or nearest one strike in the money.
Tom P: That's right.
Tom S: So like you do in debit spreads, one strike in the money, one strike out of the money, so you're going 65-35 on your deltas, you know, or inside that. If you're doing, if you're just selling premium, it's usually starting at the 30 or 35 delta and moving down to the 16 delta, just depends on how much premium's in that stock. So GoPro and Microsoft trade at the same level, $45, but we can tell that Microsoft has more liquidity with greater open interest volume and tighter spreads. On the next graph, we'll circle the 1 standard deviation strike on both sides. And so ... we just did a comparison here of Microsoft with GoPro, and you can see everything from open interests of what is it-
Tom P: 470000
Tom S: 470,000 to 176-
Tom P: Oh no, 4,700.
Tom S: Oh, I'm sorry, yeah, 4,700. And to an open interest of 176. And that's probably March options, yeah, they are. And then you can see kind of the size up on ... you can see the volume in purple, and then you can see the open interest, which is 10,000 versus 2,000, and then you can see the width of the markets, which is 1 penny versus 20 cents.
Tom P: That's right.
Tom S: It's just a good example to compare you know, open interests and liquidity. And then you can understand, hey, this is why this has higher volatility, this is why it's more difficult. If I trade GoPro, I'm going to trade small.
Tom P: Exactly.
Tom S: My takeaway from looking at strike selection and liquidity is your brain should always default to what ... just look at what we trade. So the last two days I traded crude oil S&Ps and NASDAQ futures-
Tom P: And bonds.
Tom S: And bonds. Those are probably the four most liquid commodities.
Tom P: Commodities, yes.
Tom S: Commodities, those are probably the four most liquid commodities, and I live in a world of liquidity.
Tom P: Yes.
Tom S: Not because I have any advantage of knowing what's going to happen to the bond market. I mean look at bonds now, they're back down to 03, I will be putting in ... oh my god, these things are just crazy, all over the place.
Tom P: These are impressive sell offs than bonds.
Tom S: Oh my god.
Tom P: These are impressive.
Tom S: Bonds look like death to me. And I'm going to try to buy some if they trade down to 01, and let me put some bids in below but you know what, this is ... put some bids in below ... I love the volatility we're seeing right now. And again, I just want to ... I want to just cover that one more time. I know nothing about any of these major liquid underlyings, no more than anybody else knows. All I know is they're tradable, and I also know what I don't know, which is really important. Meaning that, I know I can't pick the market direction. But what I do know is that they're cyclical, and given a reasonable size, you have tons of opportunity.
Tom P: So here is my takeaway. What happens is, the more engaged you are, the more you look at stuff, whether it's Microsoft, bonds, Spiders, GoPro, you start to build your own little watchlist of liquid products. Liquidity doesn't change day to day.
Tom S: Sure.
Tom P: In other words, Microsoft is a very liquid product. The Spiders, if you want the grand daddy of liquidity, the king [inaudible 17.57] it's Spiders. It's always a great ... it's tight markets, huge open interests, that's on everybody's list. And what happens is over a few weeks, couple of months, you build your own little universe. It might be 50 symbols, might be 100 symbols, might be 200 symbols of liquid products. And you start to say, "Where am I then finding the probabilities, or the ... excuse me, the premium that I like to get for the probabilities that I look for." You start to build your strategies around those liquid products. You don't go looking for ideas, you don't look at the news, you go to your liquid product. You have your four commodities.
Tom S: Yeah.
Tom P: I add ... I like trading in the [Vicks 18:32] a lot, I know what I can get done on the Vicks. Is it very liquid? No, but it is liquid enough for me in the size I do, you know, a couple ... I can get a couple done.
Tom S: One of the most important things, one of the most important messages we ever got out there, and I remember TP, when we started Thinkorswim, people would call in originally and they'd say, hey, what do you guys think about the stock? It was stock we never heard of before. And we'd do like ... well, I was at this seminar and this guy said to buy these calls, and remember, the market be like $6, $8. And we're like, don't trade, you know, like ... so even if the stock's going to a million, you can't make any money.
Tom P: That's right, that's right. Stay in a liquid world. So, and then look at probably what is ... then look at your premium, and decide strategy.
Tom S: Before we take a break, some really important changes to Tastytrade as of today. Tim Knight moves to 7:00 a.m. Every morning now, we call first call, Tim Knight will be on, he started today. Confirm and Send moves to 10 o'clock, because we have a bigger audience, we think it's a very valuable segment; rather than doing it at 7:20 in the morning, we're doing it at 10 o'clock now. And remember, Market Measures is at 9 o'clock. So Tim Knight at 7 o'clock, Market Measures at 9 o'clock, and Confirm and Send at 10 o'clock. Those are the changes. TP in the house. I'm Tom.
Tom P: It's a lot to swallow.
Tom S: TP in the house. I'm Tom. We'll see you in about 90 seconds.

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