Costs Unique to Options - dummies

By Joe Duarte

Because options are a little different than other securities, it’s important to recognize that they have certain characteristics that make them more expensive than trading more commonly held securities such as stocks. The main costs to consider include the following:

  • Liquidity: The ease with which you can enter and exit a trade without impacting its price, varies by option. Low liquidity securities are more expensive.

  • Time: The more time you are purchasing, the greater the cost of the option.

  • Volatility: Stocks with greater price movement in the past are expected to continue such movement in the future. The more volatile the stock, the more expensive the option.

This section covers the ways each of these items impact your trading costs.

Paying for less liquidity

Although many option contracts are actively traded with high open interest, the sheer number of contracts available to trade means there will also be those that have limited daily volume and open interest levels. This results in a wider spread, which translates to higher costs for you.

The spread is the difference between the market bid and the ask. When liquidity is low, the spread widens. Slippage is the trading term associated with money lost due to the spread. The best way to think about this cost is if you were to buy on the ask and then immediately turn around and sell the option on the bid, you would have a loss — called slippage.

Lean toward higher open interest contracts with higher volumes when trading options to reduce the impact of slippage costs. These liquid contracts can be more easily entered and exited without widening the spread and increasing your costs.

Compensating for time

All option contracts have a time value associated with them. The more time until the contract expires, the more the option costs. The only problem is, every day you own the contract, time to expiration is decreasing, and so is the option’s value associated with it. Theta is the measure that provides you with the estimated value lost on a daily basis.

When first reviewing option chains, be sure to compare options that have the same strike price but different expiration months to note the cost of time.

Paying for time means you need to consider options that reasonably reflect potential movement for the underlying. Given the wide range of strike prices and expiration months available to you, this is certainly possible.

Shelling out money for high flyers

Some stocks are more volatile and regularly swing a few percentage points each month, while other, quieter stocks take a few months for those kinds of moves. Generally, the cost of time for an option increases if the stock has proven to be more volatile in the past.