Question about option liquidity

[breeze]

Quote from dagnyt:

1) You can always sell your option - unless it is so worthless that there are no bids.

2) Yes, you can close your put (by selling) at any time - as long as it is before expiration

3) DO NOT EXERCISE. The reasons can get complicated, but as an individual investor, it's likely you will go your entire lifetime and never exercise an option. It is much better to sell them.

4) 'I want to buy option instead of stock'

That statement is frightening.

If you want to buy PUT options, then you would NEVER consider buying stock.
Are you certain you know the difference between a put and a call?

5) It is VERY difficult to make money when buying options. Please be certain you understand what you are doing before placing your money at risk.

Mark
http://blog.mdwoptions.com

Thanks for the reply. Yes, I understand the difference between put and call. The reason I want to buy put instead of shorting the stock is because the put option has 1) fixed max loss. 2) high leverage (less money tie to the trade).

Why do you say "It is VERY difficult to make money when buying options"? Can you explain a little more? I thought make money from option is similar to stock. Take a real world example of DVN, I believe the stock has a high chance to go down to 65 in 2 to 3 weeks. let's say instead of shorting DVN, I want to buy DVN Feb 2010 75 put. Assuming in two weeks, DVN goes down to 65, I sell my put option and make some profit. The reason I am not sure about this trade is that I did know how easy it is to sell my put option because this option is not traded in high volume. After reading the replies, I now understand the spread might reduce my profit quite a bit due to less volume in this option.

 

[breeze]

Quote from gkishot:

You will be always able to sell your options - there are always money makers there who are under obligation to buy them from you. The low trading volume is reflected in wider bid/ask spread.

Thanks for the reply. When you say "under obligation to buy them from you", you did not mean "obligation", you just mean they can make money from the trade because of the low bid, right? I just want to make sure I understand you correctly.

 

[jwcapital]

Quote from breeze:

Thanks for the reply. Yes, I understand the difference between put and call. The reason I want to buy put instead of shorting the stock is because the put option has 1) fixed max loss. 2) high leverage (less money tie to the trade).

Why do you say "It is VERY difficult to make money when buying options"? Can you explain a little more? I thought make money from option is similar to stock. Take a real world example of DVN, I believe the stock has a high chance to go down to 65 in 2 to 3 weeks. let's say instead of shorting DVN, I want to buy DVN Feb 2010 75 put. Assuming in two weeks, DVN goes down to 65, I sell my put option and make some profit. The reason I am not sure about this trade is that I did know how easy it is to sell my put option because this option is not traded in high volume. After reading the replies, I now understand the spread might reduce my profit quite a bit due to less volume in this option.

The biggest difference between buying the put vs shorting the stock is volatility and time. The stock has no implied volatility, and it doesn't expire. Let's suppose you have a stock at 50, and the cost of the 50 put on that stock is 1. Let's say the stock drops to 48. At that point, your option is worth 2 plus time value, and puts do lose time value quickly. If you exited the long put for 2.25, your profit is 2.25-1.00=1.25 (times 100). If you buy back the stock at 48, you have made 50-48=2 (times 100). You can be right with direction, but if the underlying moves too slow or volatility drops, the value of the option quickly drops as well. So, for your long put to be right, you need a rapid decline, and you have to be willing to exit the trade at a certain point--you need a profit target. As you know, the underlying will bounce and waiting until expiration could be foolish. There is no written rule that says you have to wait until expiration to exit a trade.

A valuable suggestion: If you wish to speculate with long puts, put on a bear put spread. Do your homework and learn everything you can about bear put spreads--placement of strikes, how they react to volatility and time, etc.

 

[gkishot]

Quote from breeze:

Thanks for the reply. When you say "under obligation to buy them from you", you did not mean "obligation", you just mean they can make money from the trade because of the low bid, right? I just want to make sure I understand you correctly.

They are under agreement with exchange to provide liquidity. That's why you should always be able to see market bid and ask quotes.

 

[breeze]

Quote from gkishot:

They are under agreement with exchange to provide liquidity. That's why you should always be able to see market bid and ask quotes.

OK, I see. Thanks.

 

[breeze]

Quote from jwcapital:

The biggest difference between buying the put vs shorting the stock is volatility and time. The stock has no implied volatility, and it doesn't expire. Let's suppose you have a stock at 50, and the cost of the 50 put on that stock is 1. Let's say the stock drops to 48. At that point, your option is worth 2 plus time value, and puts do lose time value quickly. If you exited the long put for 2.25, your profit is 2.25-1.00=1.25 (times 100). If you buy back the stock at 48, you have made 50-48=2 (times 100). You can be right with direction, but if the underlying moves too slow or volatility drops, the value of the option quickly drops as well. So, for your long put to be right, you need a rapid decline, and you have to be willing to exit the trade at a certain point--you need a profit target. As you know, the underlying will bounce and waiting until expiration could be foolish. There is no written rule that says you have to wait until expiration to exit a trade.

A valuable suggestion: If you wish to speculate with long puts, put on a bear put spread. Do your homework and learn everything you can about bear put spreads--placement of strikes, how they react to volatility and time, etc.

Thanks for the explanation and suggestion. I am reading as much as I can on option trading. The more I read the more I find option is quite complicated. Regarding your suggestion, what's the purpose to put on a bear put spread rather than just a long put? Is it to reduce cost?

 

[WanderingJew]

Quote from breeze:

Thanks for the explanation and suggestion. I am reading as much as I can on option trading. The more I read the more I find option is quite complicated. Regarding your suggestion, what's the purpose to put on a bear put spread rather than just a long put? Is it to reduce cost?

What bear puts do is limit the risk and thus the reward. What you need to do is purchase one put at higher strike price and sell another put at lower strike price- both having the same expiration date and the same number of contracts. What this does is it hedges your position-i.e reduces risk. If the underlying moves down you make a limited amount of money but at the same time if the underlying moves up your loss is limited.

 

[spindr0]

Quote from breeze:

Why do you say "It is VERY difficult to make money when buying options"? Can you explain a little more? I thought make money from option is similar to stock. Take a real world example of DVN, I believe the stock has a high chance to go down to 65 in 2 to 3 weeks. let's say instead of shorting DVN, I want to buy DVN Feb 2010 75 put. Assuming in two weeks, DVN goes down to 65, I sell my put option and make some profit.

Yep, if DVN goes to 65 in 2-3 weeks, you'll make money. But suppose the stock drops to 70 in 3 weeks. I bet your gain is no more than a point... while the stock droped 3x that.

Why is it difficult to make money buying options?

First, they decay at an increasing rate. Every day they lose a little and each day that amount increases.

As mentioned by others, they can have wide spreads (for stocks, usally wider than underlying).

They also make less than 1 pt per point of underlying move unless they're deep in the money. Your Feb 75 put has a delta near .50 so intially, you'll make 1 pt per 2 pts of stock drop.

IV change can affect your P&L.

Options have a lot more moving parts than the stock. With stock, what you see is what you get.

 

[spindr0]

Quote from WanderingJew:

What bear puts do is limit the risk and thus the reward. What you need to do is purchase one put at higher strike price and sell another put at lower strike price- both having the same expiration date and the same number of contracts. What this does is it hedges your position-i.e reduces risk. If the underlying moves down you make a limited amount of money but at the same time if the underlying moves up your loss is limited.

NEED is the wrong word. People should utilize strategies that fit their abilities as well as their risk tolerance. If one could identify and catch big moves, spreads would not be a good choice.

 

[breeze]

Quote from spindr0:

Yep, if DVN goes to 65 in 2-3 weeks, you'll make money. But suppose the stock drops to 70 in 3 weeks. I bet your gain is no more than a point... while the stock droped 3x that.

Why is it difficult to make money buying options?

First, they decay at an increasing rate. Every day they lose a little and each day that amount increases.

As mentioned by others, they can have wide spreads (for stocks, usally wider than underlying).

They also make less than 1 pt per point of underlying move unless they're deep in the money. Your Feb 75 put has a delta near .50 so intially, you'll make 1 pt per 2 pts of stock drop.

IV change can affect your P&L.

Options have a lot more moving parts than the stock. With stock, what you see is what you get.

Good explanation. Thanks.

When I long or short stocks, I use small position to control risk. Because of the small position of each trade (usually a few hundred shares), even the stock moves exactly as I expected, I only make small gains. I thought option would allow me to put on much bigger position and therefore gains with fixed max risk. Of course I was a little wishful thinking. Anyway, I am going to continue to trade stocks. At the same time, I will try to learn option trade as much as possible.