The markets are closed today in observance of Memorial Day. However, it should be an exciting start to the trading week tomorrow.
Now, one thing I notice after a 3-day break like the one we just had… is that some traders sometimes come in too relaxed and not focused on enough risk management…
… or they get too excited, try to jump into everything, and make avoidable trading mistakes in the process.
Let’s face it… the holiday break is meant for relaxing and not thinking about work or money. I don’t blame you if haven’t thought much about the trading week yet.
But come tomorrow morning… you need to stay focused and pay attention to detail.
You see, one of the biggest mistakes traders will make tomorrow is slippage.
Now, if you haven’t heard of the term, slippage is the difference between the price you expect to enter/exit a trade versus the actual price that you get filled at.
For example, check out this options chain in STAMPS.COM (STMP).
Now let’s assume you wanted to buy the at-the-money (ATM) call options, the $35 strike. As you can see above, the spread is $1.90 by $2.55.
If you enter a market order you might get filled at that $2.55 price. And let’s just say something happened and you were forced to get out, a sell at the market order might get you filled at $1.90.
What does this all mean?
There is a 25% difference between the bid and the ask price. That is an unnecessary hurdle you need to overcome.
This one mistake can reduce your chances of success to almost zero. However, I won’t let it happen to you.
Read on for my best tips on avoiding trade slippage, and a whole lot more.
Options Trading: The Cost of Doing Business
Make no mistake about it… slippage is just the cost of doing business. However, if you want to improve your odds of success, then you need to put yourself in a position to win.
(Weekly Money Multiplier clients get my alerts, and portfolio feed in real-time, not a subscriber? Click here to join)
In other words, you want to keep your margin of error small.
How do we do that?
- Trade options with competitive bid-ask spreads.
For example, SPY is one of my favorite ETFs to trade options on, and it also happens to be one of the most liquid in the market.
If you take a look at the ATM options in SPY, you’ll see that difference between the bid and ask is about 2 cents wide (for the $283 calls). Now, that sounds a lot better than $0.65 spread we saw in STMP earlier.
A wide bid-ask spread means market participants aren’t interested… and market makers have reason to price the options fair if they don’t have to compete to make a market.
Looking for Clues: Volume and Open Interest
Now, let’s pull up the option chain back up in STMP. This time we’ll change the settings to see how much volume and open interest the options have.
Now, if you look above, only 82 calls of the $35 strike traded on Friday. And prior to that, there were only 7 contracts of open interest.
In other words, these options aren’t very active… and you’ll need an amazing reason to want to buy calls…because the slippage will chop you up…making it harder to profit.
Instead, you want to see something more like this:
Check out the open interest in the $128 calls in TLT options, over 12K contracts, and a competitive bid-ask spread.
That is just one of the reasons why I love trading TLT options…
(I like to trade hundreds of options contract, liquidity matters to me, if you want to know what I’m going to be trading tomorrow, click here to join WMM)
Learn How To Work The Order
Now, if you are trading options with a competitive bid-ask spread, then you can get away with placing market orders. On the other hand, if the spread is wide, then you want to use a limit order.
A limit order tells your broker that you are willing to buy or sell an option at a specific price or better.
For example, instead of paying $2.55 for the ATM calls in STMP, maybe try to place a limit for $2.20 for one contract to see if the market makers will adjust their price.
Why one contract?
Well, what if you get hit right away… it probably means you could have gotten an even better price. Maybe $2.10 or $2.05.
After all, the difference between paying 2.05 and 2.55 could mean $5,000 to $10,000 in slippage for someone who trades the amount of contracts I do.
The futures are trading right now… and tomorrow you might be eager to jump in. But do yourself a favor, pay attention to the details, specifically the bid-ask spread.
Enjoy the rest of your Memorial Day… and if you want to know what I’ll be trading tomorrow then click here.
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