Liquidity and Trading Options

Have you stayed away from options because you thought they were risky? As you’ll see in this article there are many ways to invest in options. Some may be a bit risky, but some can actually be used to reduce your risk.

This article is part of our series on options investing, in which The Motley Fool is sharing a number of strategies you can use to get better results from your investment portfolio.

As with so many things, investing has gotten increasingly sophisticated over the years. Gone are the days when the only choices you had for your investment dollars were stocks and old-fashioned mutual funds. Now, you have a wealth of new strategies available to you — and many of them can help you get the returns you want without the risk you can’t afford to take.

Over the past month, we’ve taken a look at various ways that you can use options to improve your investing experience. Whether you’re trying to boost the income from your portfolio, protect yourself from unexpected losses, or take advantage of bargain prices to buy stocks on the cheap, options can help you get the job done.

But one question largely remained unanswered: Is there a best type of stock that matches up well with these options strategies? To close out our options investing series, let’s take a closer look at how different strategies work with different stocks.

The key to options happiness
The most important thing about trading options is understanding that you won’t always find the same level of liquidity in the options market as you do when you buy and sell stocks. That means that strategies that look like they’d work well in theory aren’t always going to be practical.

For instance, look at DryShips (Nasdaq: DRYS  ) . The stock is at the epicenter of the shipping industry, with plans to spin off its Ocean Rig deepwater drillships segment to focus on its core transportation business. Yet despite the fact that the stock trades almost 10 million shares each day on average, you’ll usually find volume of less than 100 contracts of any particular option you might want to buy or sell — often much less than that. Moreover, the spreads between bid and ask prices are quite wide — almost 10% in some cases.

By contrast, popular stocks give you the kind of liquidity that can make a real difference to your options investing results. For instance, a range of options for Caterpillar (NYSE: CAT  ) , Boeing (NYSE: BA  ) , and United Technologies (NYSE: UTX  ) traded hundreds of contracts yesterday, with a few numbering in the thousands. With these companies tied to U.S. government spending and the global economy in general, their options let you take a stand on your view of the future.

What liquidity lets you do
Because liquidity is so important, you have to separate trade-intensive strategies from those that don’t require many trades. For instance, one obvious candidate for a LEAP option is Dendreon (Nasdaq: DNDN  ) , which has a make-or-break proposition in its Provenge cancertreatment. But with fairly wide spreads, you’ll want to use limit orders to make sure you get a good entry point — and then stick with your position rather than making frequent trades.

On the other hand, stocks with more liquid options markets — which include most of the Dow’s and Nasdaq 100’s components, along with the larger stocks in the S&P 500 — give you much more flexibility to do what you want. A strategy like a diagonal call, which requires you to buy a long-term option but also write successive short-term options repeatedly, works better for Intel (Nasdaq: INTC  ) and Dow Chemical (NYSE: DOW  ) , which have the volume to let you make multiple trades. The same goes for other complicated positions, including straddles and strangles.

That doesn’t mean you can’t use simple options strategies like writing puts or calls on liquid stocks. But with stocks that don’t have the options-market liquidity that can support more complex trades, you’ll want to limit yourself to those simple strategies in order to keep trading costs and bid-ask spread friction to a minimum.

Open your eyes
With the stock market as risky as it’s been lately, knowing how to use options to protect yourself while producing valuable profit opportunities has become more important than ever. Whether you seek out the higher income from covered calls, the profit potential from bull call spreads, or a host of other goals, options can help give you the answers you need.

See Motley Fool for the entire article

Option Trading Secrets

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