Year-End Options Conundrum

The grinding-higher action combined with the fact that we're now heading into what is typically the quietest two-week period of the year creates something of a conundrum for option trading. Options are too cheap to sell, but the low-volatility environment and accelerated time decay created by the holidays create a headwind to buying options or owning premium.

For that reason, my general approach for the next week will be to focus on buying options with a February or later-dated expiration in hopes of possibly legging into the sale of January to create some calendar spreads. The goal is to become net long gamma at a relatively low price as we head into the second week of January, when the next round of earnings reports will start.

Some other basic option rules of thumb for staying out of trouble, or at least reducing the chances of losing money simply as the result of getting stuck in an illiquid or roach-motel situation, include:

Start with stocks that have reasonably high average daily volume, 500,000 shares or more. This provides some degree of a back door for exiting or hedging a position, should things turn sour.

Focus on the most active strikes with the largest open interest. These are usually the near-the-money strikes, the two closest strikes above and below the stock's current price, in the two front expiration months. Note that sometimes the strikes with large open interest are not the most active. There are some cases in which someone establishes a large position in a given strike through one or two large transactions and the strike has no volume for an extended period.

Always use limit prices for initiating a position. But if the bid/ask spreads are less than 10 cents, I wouldn't try to split the difference. Trying to save a nickel could cost you the trade. Be willing to establish half the position at the bid (if selling) or offer (if buying) and then work the balance.

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Steven Smith writes regularly for TheStreet.com. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback; click here to send him an email.

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