Options Traders: Watch Out For This Little-Known Income Killer

Using a covered call strategy can be a great way to generate steady returns in your portfolio. As a general rule, I expect my covered call trades to increase my capital by about 25% to 35% per year, depending on the market environment.

(If you're new to the covered call strategy, click here for an introduction to how this strategy works.)

Whenever I set up a new covered call trade, there are a number of different dynamics to be aware of.

I always want to start with an underlying stock that has a high probability of increasing in price. I typically look for stocks with strong fundamental growth and a chart pattern that indicates investors are steadily buying the stock.

Next, I want to make sure that the option contract we use has plenty of premium built into it. Since we make our income by selling attractively priced call options, we need to make sure we're getting a good value for the contracts we sell.

There are a number of variables that go into picking the right options contract. In previous articles, we've discussed the need to carefully select the right strike price and the right expiration date.

It's also important to make sure that the option contract we select has plenty of liquidity and a narrow bid/ask spread. This ensures that we are able to enter (and exit) our position efficiently, without losing money to slippage or poor market dynamics.

The idea of liquidity is very important for option trades. Liquidity measures how deep a particular market is -- or more importantly, how easily a trader can buy or sell a material amount of stock or option contracts within that market.

Many traders who might otherwise be profitable wind up taking losses because of the lack of liquidity in their specific markets. For instance, if an option price is quoted at $2.50 but by the time a trader sells all of his contracts, the effective price drops to $1.75, this trader will have a severely reduced profit (if not a loss).

For most well-known stocks, you can simply look at the "last" price to get a good idea of where the stock is trading and what you as an individual investor would have to pay for a full position. But for option contracts, we have to be much more careful about verifying the price at which we can sell our contracts. In particular, we need to look at what actually goes into a price quote for these options.

Analyzing Two Different Price Points

For any publicly traded instrument (including stocks) there are actually two prices that every trader needs to be aware of: the bid price and the ask price.

Bid price: The price market makers are "bidding" for a stock or option contract. In other words, the amount that the market is willing to pay for your stock or option contract.

Ask price: The price market makers are "asking" for a stock or option contract. In other words, the amount that the market requires to sell a stock or option contract to you.

It is important to remember that when we are buyers, we look specifically at the ask price. And when we are sellers, we can expect to get paid the bid price when the sell order is executed.

Market makers typically make their money because of the spread between these two price points. For instance, an options trader on the NYSE may offer a contract at $1.50 and bid a contract at $1.45. This means that the market maker is willing to buy at $1.45 and sell at $1.50. His profit is the $0.05 difference between the two prices.

Whenever I set up a covered call trade, I look specifically at the difference between the bid and the ask price as one metric to determine how liquid this market is.

Tight And Wide Bid/Ask Spreads

A tight spread is one of the best indicators of a well-functioning, liquid market for an options contract. When there is plenty of competition in the market for a particular option contract (several market makers jockeying for position), we as traders reap the benefits.

Several different market makers competing to buy will lift the bid. And at the same time, if there are market makers competing with each other to sell these same contracts, the ask price will naturally fall. The result is a very tight spread between the bid and the ask price.

For contracts trading with a price at or below $5, I like to see no more than a $0.10 spread, and often we can find setups with a spread that is $0.05 or less.

To put this in perspective, a $3 stock trading with a $0.15 spread can wind up eating into your profits significantly. If you sell a contract and then wind up buying that contract back to close the trade, the spread between the bid and ask is actually 5% of the notional value of the contract. And this is in addition to the commission fees that you pay your broker.

Even if you only sell the call contract (and then let the contract expire or be exercised), you are still essentially paying half of the spread. And in this case, giving up 2.5 percentage points of your option premium can have a profound effect on your long-term growth rate.

Since we are typically attempting to book a few percentage points over the course of six to eight weeks, it is very important for us to pay attention to the liquidity (and in particular, the bid/ask spread) of the option contracts that we trade.

Liquid Underlying Stock More Important Than Open Interest

If you listen to novice option traders, you'll hear them talk a lot about "open interest" for individual contracts. Open interest refers to the number of contracts that are actually in effect at a given time.

For instance, if I decided to set up a covered call trade on BP (NYSE: BP), I might buy the stock and sell the March $45 calls. Someone else (most likely a market maker) would have to take the other side of my trade and buy these calls from me. This new contract would increase the open interest of the BP Mar 45 Calls. If several people set up the same trade, the open interest would increase dramatically.

In today's market, low open interest doesn't necessarily mean that the option contracts are illiquid. Because of the trading technology and the number of market makers operating on the option exchanges, we can expect to have a relatively liquid options market, provided the underlying stock is heavily traded.

This is because market makers can quickly and easily buy the contracts from us, and then immediately hedge their risk by selling the liquid stock. The entire process typically happens instantaneously, with computers handling all of the executions.

Action to Take -- The key takeaway for us as covered call traders is to make sure that we are choosing liquid stocks that are actively traded, and to watch the bid/ask spread of the option contracts carefully. The $0.05-$0.10 bid/ask spread for normally priced options is a good rule of thumb.

And remember, if the spread is too wide for a trade that you want to set up, it doesn't hurt to pass. There are so many great covered call setups available, it just doesn't make sense to compromise on this metric and put your potential profits at risk.

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This article was originally published at ProfitableTrading.com