Step Into the Liquidity

Learn the rules of thumb for avoiding black holes. Plus, California Pizza Kitchen.
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This column was originally published on RealMoney on Nov. 10 at 1:06 p.m. EST. It's being republished as a bonus for TheStreet.com readers.

Reader Mark M. asks, "Do you set thresholds as far as open interest and volume are concerned when evaluating a possible options position? Liquidity seemed like it might be an issue, especially in the

California Pizza Kitchen

(CPKI)

position."

This is a great question, and points up my love/hate relationship with using options. Dual listing, electronic trading, decimal pricing, reduced commissions, etc. absolutely have leveled the playing field and revolutionized the industry to the point where it would be negligent

not

to always look at the option chain for alternatives to trading the underlying security.

But while I believe that almost any stock position can be created and improved upon by using the leverage and flexibility of options, the fact is that once you move beyond the top 20 index and ETF products and 100 most active equity listings, the other 6,000 optionable issues have a severe lack of liquidity. And that can create a nearly insurmountable headwind to being able to use options as a profitable short-term trading tool.

My rules of thumb for avoiding the black holes, or options that trade "by appointment only" are:

    Avoid issues in which the near-the-money strikes have fewer than 200 or 300 contracts open.

    Avoid issues in which the bid/ask spread for options trading below $2 is wider than 30 cents; for options under $1, the b/a should be only 20 cents wide.

    Generally, don't trade options on stocks priced under $15, unless the implied volatility is above 50%.

    The option must be multiply listed, that is, it must trade on more than one exchange.

    California Pizza Kitchen is on the bubble in terms of the first two criteria, but trips on hurdles 3 and 4. And as a stock that I had an opinion on -- a very wrong opinion, as it turned out -- I was willing to accept the "slippage" or pay a higher VIG to place a longer-term directional bet.

    In this case, I was wrong. Shares have tanked following earnings. But the value of the options, as both a means of gaining leverage and reducing risk, performed as expected.

    The position was originally established by purchasing the January $30 calls at $3.40 per contract when the stock was trading $32.80 two weeks ago. The stock has declined some 8% to the $30 level today, and the calls are trading around $2, or 30% lower, for a $1,400 loss on the 10-contract position. If I had bought $1,000 shares at $32.80, I'd be out $2,800 so far.

    Of course, the percentage loss on the stock is lower, just as if the stock had climbed, the option would have delivered a larger percentage gain -- but possibly a smaller dollar amount. The issue of using delta to determine contract size can be taken up again at another time. The point here is that the options basically performed as expected.

    But for positions that are not straight directional bets or for strategies that are probability-based such as butterflies or condors or even basic credit spreads, an option market that is liquid and offers tight bid/ask spreads is crucial to establishing an attractive risk/reward profile. If you give away a 20-cent edge or 15% -20% on both the exit and entry on multiple strikes, it can mean the difference between realizing a profit and incurring a loss. At best, it means you'll be forced to hold spread positions, especially those done for a credit, right until expiration to realize a profit.

    Worse is that even only slightly adverse conditions can turn what seemed to be a manageable limited risk into an unexpectedly large loss. Most typically, the trade causes frustration; despite a correct market hypothesis, the result is a scratch or a position that fails to deliver a measurable profit.

    As the saying goes, "There is no such thing as a good trade done at a bad price."

    Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. 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;

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