Monday, June 13, 2011

BBVA - target hit, but lessons to be learned!


First, things first, the chart:


Lots going on in this chart. The main thing to get out of it is this - I entered this trade on June 8th (the candle in green) looking for a move down to the most recent low.

And guess what? It did just that with an amazingly bearish candle just two days later. That was a big move for the stock. So, you're probably asking yourself how many gazillions of dollars did I make on this - because that was as sweet trade.

Well, I made $0.10. As in ten cents, and in real dollars I'm talking an entire Alexander Hamilton. Enough for a lunch by myself somewhere. And, once I take out the $3 I paid in commissions on this trade, I'm now down to $7 George Washington's. Which still gets me a lunch, just at a crappier place.

The lesson to be learned here is that you must make sure you are placing trades that have a good probability of making you money once you get the desired move from the stock. Hindsight is always 20/20, but there's two things to learn from this.

Thing #1 - let's look at the broker's software I use for placing the trade. I have the day that I placed the trade in this screen and my trade is highlighted on the left side of the screen:


You'll see first two numbers for my October 11 Put is $1.05 and $1.20. The $1.05 is what the broker will pay you for this Put if you already own it. The $1.20 is what the broker will charge you to buy this Put from him/her. This is called the "bid/ask spread" and is how the broker makes their money.

The problem is when this bid/ask spread is "wide". Meaning there's a bit of a difference between the two. In this case, there was $0.15 difference, which is a lot considering the price to buy the Put was $1.20. That spread was 12.5% of the cost of the Put!!!

This still may not mean a lot to you, but it basically means that your stock REALLY HAS GOT TO MOVE BIG TIME in order to compensate for this bid/ask spread. Basically you are starting 12.5% in the HOLE.

Here's another illustration of a bid/ask spread, but this time of a heavily traded ETF, the SPY:


Again looking at the highlighted Put option, you could sell it if you had one to the broker for $3.00, or you can buy one from the broker for $3.05. The difference in this is only $0.05. However, that nickel only represents 1.6% of the total cost to buy the Put. A HUGE DIFFERENCE compared to the prior example.

Thing #2 - A low priced stock has low priced options, in general. However, it also usually has low priced movements as well. A 10% move in a $10 stock will bring you significantly less NET profit as compared to a 10% move in a $30 stock when trading the same amount of option contracts.

Yes, there's an argument that ROI% is the same and it's valid. But, you gotta remember commissions. The more options you buy, the more you are paying in commissions which will ultimately eat more of your NET ROI%.

Example: to get the exact same gross outcomes, you can compare:
1 option contract of a $30 stock with a 10% movement
vs.
3 option contracts of a $10 with a 10% movement

Both will give you the same gross profit of $3. However with the $30 stock, you'll only have 1 set of commissions (you get charged to buy and to sell the option both). Where as the $10 stock will have 3 sets of commissions.

So, my point is this:
1. Keep the bid/ask as small as possible. There's no hard and fast rule, come up with one on your own.
And
2. I'm not trading anything under $15 stock price from now on.

There's a ton of foolery that the marker maker puts into the option pricing, I believe the formula is close to the one on this chalkboard:

But, if you can cherry pick the best trade set ups, with the smallest bid/asks and don't go too low in stock price, then you'll have better profitable ROI%s.

All in all, I'm still happy with this trade. Praise the LORD for it!! I did make a little (literally) bit of money and I re-learned some valuable lessons.


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