Case Study- "Acquaintance"
Monday, December 31, 2007 at 12:02PM I was the lucky recipient of some unsolicited correspondence today. Well...fortunately I am the lucky recipient of truckloads of unsolicited correspondence every day. However, today's mail was different. One piece I received today was from an old acquaintance. I was baffled at first, as I didn't really know "acquaintance" too well. As I read his mail, it was apparent that "acquaintance" wasn't contacting me out of the blue. That would have been too easy. As I continued to read, he explained that somehow my name had come up in a conversation with some of his friends about the stock market and about young and handsome future billionaires...and apparently the name Option Addict entered the conversation. "Acquaintance" admitted to getting overly excited because he knew me, and was intrigued about my reputation, money making capabilities, upcoming humanitarian awards, and what I was doing with my life in general. As luck would have it...he finds out, I am an active trader and a mediocre blogger....and guess what? "Acquaintance" happens to be a person with $2000.00 and desperately seeking financial advice!
I deleted his e-mail.
However...before deleting this e-mail, he mentioned where he was trading and the type of trading he was doing. He mentioned he had been dabbling in options trading. He had only placed a half dozen trades, and they were all winners!
The problem was...he was losing money.
"Acquaintance" had surfaced an important aspect of trading. His e-mail didn't die in vain. Options trading can require forking over some big time expenses. As expressed in percentages, you can be cutting out a big piece of your profits in commissions and spreads if you are not careful.
I fingered "acquaintance" as the typical option trader that shops for options like they shop for anything else. By price. I also know that his online broker is notorious for being unreasonable in the commission department. I also assume that "acquaintance" doesn't choose or turn down option trades based on things like open interest, liquidity, spreads, etc. I picture him to be of the "penny stock species."
"If I buy this stock for $.01 and it goes to $.02...I DOUBLE MY MONEY!!!"
Wrong. If you buy a stock for $.01, you are a moron.
Anyway, let me throw out a scenario and some numbers to make my point...
"Acquaintance" gets an e-mail about a huge opportunity getting ready to explode in ABCD.OB. Therefore, he expects the stock to move from $20 to $200 per share next week.
Rather than own the stock, he shops for call options. As he surveys the options he finds the two options he must choose between...at-the-money or out-the-money. Why? Because they are cheaper than in-the-money.
Looking at the choice in premiums...he is satisfied with either. "Acquaintance" prefers the 22.50 because it is cheapest, but he realizes either are cheaper than buying the stock.
He has $2000.00 to invest. He is not interested in "letting it ride." Despite having no concept of position sizing or money management, he has decided on purchasing 1 contract at the 20 strike. Admirable.
To enter this trade, he is going to have to pay $1.55 per contract. Since he purchases only 1 portion, he spends $155. The commission spent is $14.95. He has banked $165 of his account (over 8%!) on this trade.
Little does "acquaintance" know, that upon purchasing this option, he can now sell it back to the market maker (the only living sole trading these options beside "acquaintance") for $1.05 ($105).
He is into the trade for $169.95. If he wanted to get out of this trade...he can still get $105 out of it, which would net a 36% loss on the trade; 3% loss to his account.
Keep in mind that the stock hasn't even moved yet.
Even with a decent delta of .50...with no open interest or liquidity, the spread gets wider, implied volatility shifts, and time melts away... enough to make sure that you always get screwed in options like this.
Even if the stock moves higher, it will take a gift from the trading gods to get that ask price to an amount that will make "acquaintance" profitable on this trade.
The probability of success here is nil. The stock has to move a ton to make money. More than likely, it will move a little...not at all...move down a little...or move down a lot. All of which result in a sure loss for "acquaintance."
In the end, "acquaintance" has taught us a few important lessons.
- A liquid option, with a tight spread can save you big percentages in a trade. (32% of this premium is the spread between bid/ask)
- Check open interest. If you are the only person "interested" this is probably a bad sign.
- Commissions can be a major factor in your trading, especially with smaller account sizes.
- Finally, don't send me unsolicited e-mails.
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Reader Comments (41)
I'm somewhat curious about letting it ride. If you're working with a small account (as I am, for example), would you take an all or nothing type approach? While the prospect of hitting it big (ala SOLF or VIP) is nice, there's always that underlying risk of doom.
Classic Post.....love it! One the plethora of reasons, you are the man!
Cheers,
Arty
Jeff,
For non IT customers (who are getting 1.50 a contract commissions) through TOS, what would you consider not unreasonable in the commission department.
I would still position size, but in larger percentages obviously.
It all depends on how important that $2k is to you.
I'd never let it ride on one trade...but maybe 4 or 5 if I was ok with losing the whole thing. As I made more money, I would change that philosophy real quick and trade smaller position sizes.
Jym,
$14.95.
Jeff,
Thanks.
Thats what I pay now through OX. I have been tempted to sign up with IT just for the 1.50 commissions. I don't usually trade more than 5 contracts at a time so the savings could be substantial. One of these days I'll have to run all the numbers and see if it makes sense.
Pardon me all for rambling.
Jym, you do not need to have an IT account to open a TOS account. You will save a lot of money over OX. When I first started trading I was with OX but switched about a year ago.
Did you mean, ToS? You don't have to be an Investools customer to trade with ToS.
I mean ToS
I thought the 1.50 comissions with no minimum were only for IT customers. (I think I saw it on IT's website) If it's for everyone, I'll have an account open in about 3 minutes.
I trade thru IB and pay .70 per Options Contract. Is TOS Flat Rate at 1.50 per trade no matter the numbe rof contracts? I pay no monthly fees nor hidden costs - just .70 per contract that is taken out as soon as I am filled.
I have a good childhood friend who has mad a fortune in the market and about eight years ago, I asked him What I should invest in with my savings. He told me to invest in myself. Not only that, he doesnt touch accounts less than $100,000. I think Thats what I'm doing.
Hey jym.. you are not rambling, I am.
Happy new Year. I think I am going to grab a drink.
Karl,
Check out
https://www.thinkorswim.com/tos/displayITLanding.tos?srcCode=0906_02
Looks like it's 1.50 flat for IT customers.
DG,
Thanks for the info.
I'm trying out their papermoney but the learning curve is a bit steep.
Jeff,
Are we gonna end the year with a 'Cast?
Sorry all for the plethora of posts.
jym, once you get your ToS account setup, click on the HELP tab at the top (after you download the desktop version). There, you can view video tutorials that will familiarize you with their setup. They are very helpful. And btw, good to see you, too!
Krystal,
Thanks
;-)
ToS Commissions is not the only reason to be with them. The $1.50 a contract is great, but before I was with ToS I had 2 other trading accounts. In both of those other accounts I would get filled at the average of the Bid/Ask about 10% of the time. With ToS I get filled that way over 1/2 of the time.
With Jeff's example getting filled at the average would save you $25- on both ends. If you get good fills the commission doesn't even cross my mind.
The really cool thing is, if you can sell options to people like Jeff's acquaintance. I didn't like the spreads on SPWR on Christmas Eve, so I sold some $100 and some $90 January puts. The price action has gone against me for 3 days and each day the puts have made me money.
Flying Pro
TOS definitely has better execution on trades - fast and great fill prices - I left OX because they took too long to fill or did not fill at all unless I was at the ask price or very close to it. Also TOS tools are much better - setting up an IC on OX was a pain - and closing it out was even worse - TOS does it all with a single click!
Thanks all for the input.
Keep it coming!
Besides the low commissions on ToS, I just learned how to get filled at better than Mid of Bid/Ask. Under the options chain on the Trade tab, you will see a letter next to the Ask price. If you hover your curser over that letter, the word Trade Grid comes up, click on that letter and it will populate something in the Trade Grid section of that tab above the option chain. You will then see all the exchanges that are listing prices and the associated number of contracts for that Bid and Ask price. These are the so called "market makers" of the electronic exchange we trade on today.
For example, if the Bid is 2.00 and the Ask is 2.50, ToS shows the Mid (or Mark) as 2.25. If I want to buy the option and there are already a large number of contracts waiting to purchase at 2.00, I will typically enter my offer price to buy at 2.05 - I will usually get filled right away at this price and save myself .20 on every contract in this case by not paying 2.25 for it. You can do the same thing conversely if you want to sell an option by looking at the Ask column.
What is cool is once you place your order, you can see where your order is in queue (your ToS account number shows up right there with the the other exchanges) to be filled and adjust your offer accordingly if you want to be filled more quickly.
This awesome feature of saving pennies to 30 cents per contract will add up quickly in your account - often they pay for the cost of my commission alone plus some.
Happy New Year and happy trading in 2008.
Jeff,
Thanks once again for the life lesson in trading. Great post and advice. You have taught it all but it never hurts to be reminded of the basics. Here's to a rockin 2008 with your great teaching.
Brent
This conversation will improve dramatically after a glass or two of champagne. I have boasted many times about my .70 commissions with Interactive Brokers. But they don't have half the cool things that TOS has. I am going to switch my account to TOS once they perfect their "Great White North" version (it comes with a husky instead of a monkey.)
Jeff this thread is one of your most entertaining posts this year. A perfect way to end the year. I was going to post an Angry Trader chapter but I don't want to appear like I'm trying to compete. Besides... I can't compete with this one.
Top Notch, my friend. Have a great New Year. Keep the swervy bits straight, and the straight bits swervy. It'll keep everyone on their toes.
Cheers!!
Chris and Catherine.
What do you think about SNDK?
jym,
see if TOS is still giving $50 kickback for transferring your account.
Happy New Year All
Sam, what do YOU see when you look at SNDK? :)
Opps,
Forgot ToS has some deal that if you place 40 trades in a month they give you an $39.95.... So your first 40 trades have a commission of $0.50 ;-)
HAPPY NEW YEAR!!!!
I have been an infrequent lurker the last week because I cashed out to enjoy family for the holiday. I do not think trading and family are mutually exclusive (a reference to my old statistics teachers) but it was a decision I am happy with. I did lose out on virtual profits in VIP and POT but I am ok with that. I still exited those postions with a profit. The rest I refuse to discuss.
C2- great to have you back in full force and full wit.
I love TOS for those that want my unsolicited opinion. Their customer service is exceptional and another bonus is that if you make >40 trades per month, they credit your account $40 to pay for your broadband access. Their free seminars are worth your time and contribute to your trading knowledge significantly. I have no negative comments about TOS.
Jeff, Looking forward to 2008. Thank you for all that you do.
Losing money in 2007.....regretable.
besting Kohler's returns in 2007....unlikely
Pissing off "Greatdealsforyou"....PRICELESS !!!
I know that you are very concerned about the SEC!! But knowing that he has yet to deliver on a promise, I think you can rest easy tonight.
OA's, I am very much looking forward to working with you in 2008 and making money.
Raimo, If I wasn't a Veterinarian and you were not a hunter, and I was a Type A, and you were not a higher Type, and if I was confrontational and you were not, and if wrote lousy poems like you do, and if I did not own a small Swiss Army Knife and you own one like OJ's, and if I did not wear Top Siders while you wear steel toed army boots, We could be the best of friends!! I unfortunately outed myself as the Phantom. Could you not return the favor and let the group know that you are voting for Hillary! Happy New Year to my nemesis!!
OA's a wondering,
All of the things stated about TOS are true. The "pay for your high speed internet gimmick", true! The $50 bucks for switching over ($51.50 Canadian) true! And the Trade grid Christina mentions, which is an awesome post Christina, is true too. So end of the day you can trade like two ferrets f*&k@#g in a burlap sack, and commissions and spreads have little to no effect on your trades. Providing you are an active trader and you follow Jeff's simple guidelines.
Jeff not to kill a dead horse, but as C2 stated, great post! Can't confirm the "husky" or the "Yeddi" instead of the monkey, but it is a great brokerage even for the Canucks!
Cheers,
ARTY
Arty,
"trade like two ferrets f*&k@#g in a burlap sack"....
Is that you or is your Grandma talking again?? Either way, it is another classic.
ARTY,
When I was 4 years old we went crabbing with my grandparents and stuffed them in a burlap bag to drive home and cook them. My grandparents told me they were having a party in there... I didn't realize it was an orgy!!
Thanks for clarifying that. Cheers, my friend.
Sean, nice to see you again. A few glasses of champaign and PP should whip up a doozy.
First of all,
I want to give Kohler unbelievable kudos for his poker face. When I had thought I identified Sean as the PP in August "wrote it on the blog", (I asked Jeff to confirm I was wrong. I had worked so hard reading back through posts that identified him.. See Blog Archives photo: August 30th with Eric, Sue, Jeff, and I) Jeff kept the PP's identity a secret. Amazing, it was so convincing, I stopped looking at that point because nothing pointed to anyone else.
Now as far as the Ferret's and the Crabs, you all are going to have to figure that relationship out for yourselves.
Finally, my grandma would have said something like, "For fucks sakes, it's not like I've never seen some balls dropping!"
Happy new year!
Cheers,
Arty
Let me be the first to say in 2008, Happy New Year!
Jim
HAppy HAPPY New Year Jeff & OAs. 2@@8 will be the greatest!
Happy New year to Jeff and all the OA's. I wish you all the best of luck with life and trading in 2008.
Sean (PP),
You are considered a friend of mine buddy...regardless if we don't agree an everything. And I don't carry a swiss army knife, I traded that in for a Cold Steel fighting knife when the phantom appeared and I was on the hunt! LOL....
Wishing you and your family a prosperous New Year!!
A Happy & Profitable New Year Jeff & All the Great OAs
Christina, thanks for the informative post. i've pulled up the trade grid accidently, but have never used it to set my price.
Julia
I think TOS might rebate you $39.95 for each account that you make more than 40 trades a month in. I noticed that I got the rebate in several accounts that I must have exceeded the 40 trade speed limit in. I just never paid attention to whether or not they all got them or just the first account to exceed 40 in a month. Also... if you tell TOS you are thinking of changing to TradeKing they will put you on the phone with one of the big Kahunas (Preston or Sosnoff, I can't remember who I talked to) and they will give you an even better deal. You can have your choice of $1.25 trades or they will match TradeKing's $4.95 plus plus $0.65 a contract or a flat $9.95 for all the contracts you want. If you trade 10 lots or more TradeKing makes sense commission-wise but IMHO no one touches TOS as far as being the best all around on line brokerage. I may have shelled out enough in commissions to buy a nice sports car but to me their tools and service is worth it.
Stan
Jeff,
I'm back in full force in the am. Thanks as always for the watch list. I'm actually giddy over the list it's so good. Really.
Kim
Klean Kups!
Excellent post. Happy new year to all.
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