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Picking The Wrong Stock Is Costing You $3,840 Per Year (Bid Ask Spread) - YouTube
Channel: Option Alpha
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Hey everyone.
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This is Kirk, here again at optionalpha.com.
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In this video, I want to talk about the invisible
cost of slippage.
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Too often, I鈥檒l hear traders complain and
whine about their super high commission cost
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that their broker is charging them.
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While these costs are undoubtedly an important
part of your ability to generate a profit,
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there is a hidden troll that is stealing much
more than your broker and you don't even know
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about it most of the time.
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One of the main things you鈥檒l hear professional
traders harp on is the idea of trading products
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with high liquidity.
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There鈥檚 a reason I care so much about liquidity
besides the ability to quickly enter and exit
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trades which of course is nice in any market.
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As you'll see, it all comes down to slippage.
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Slippage is the seemingly low dollar amount
and often invisible or unfelt amount you lose
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on each trade due to the bid ask spread differential.
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In this video, we鈥檒l show you why slippage
and poor underlying stock selection cost you
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nearly $3,800 each year on the low end.
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Let鈥檚 first take in an example here by looking
at SPY slippage.
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SPY is the ETF that tracks the S&P 500 and
one of the most active, highly traded securities
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out there.
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You can see that the SPY has a daily volume
of around 74 million contracts or more.
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Just at the time that we took this video,
it鈥檚 about 74 million contracts that were
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being traded.
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You can see most of the options that it trades
have bid ask spreads that are about a penny
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wide, so 104 to 105.
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Even options that are far out of the money
are at most about two pennies wide, 62 to
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64.
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It鈥檚 very tight markets and that's because
of the high liquidity and open interest on
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both sides.
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You can see the market breath and the market
depth is there for SPY.
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The same thing is true of other non-ETF securities
like Apple.
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Apple is a highly traded security.
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At the time of this video, it鈥檚 just about
the afternoon and it had about 32 million
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contracts or shares traded in the underlying
stock.
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The options on both sides are highly liquid
with a lot of volume and open interest and
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you can see that options that are at the money
are trading with a penny wide or two penny
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wide bid ask spread, so very, very minimal
slippage.
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Now, even with these incredibly tight bid
ask spreads, we鈥檒l still lose money on a
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slippage trade with these super liquid options.
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Here's how the math works out exactly.
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If you have a penny wide bid ask spread and
you times that by a contract multiplier which
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is 100 because we always times the option
price by 100 to get the true value, and we
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times that by just one contract that we鈥檙e
trading and two sides of the trades, so we
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have to open a trade and we have to close
a trade, so just one contract that we鈥檙e
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trading in Apple or SPY, an open and a closing
trade, we鈥檙e going to lose about $2 per
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trade just in the slippage.
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This means that every single time we trade
just one option contract in either Apple or
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SPY, we鈥檙e likely to lose just $2 per contract
in slippage.
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That means if we traded each stock just one
time each month for an entire year, we lose
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a total of $48 in slippage.
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Don鈥檛 let this deter you though.
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The profits we generate trading just one spread
are likely more than going to cover the slippage
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and commission cost each year.
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But what about other stocks that are out there?
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What about other stocks that maybe don't have
the high liquidity that Apple and SPY have?
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If stocks like Apple and SPY still cost us
$48 per year in slippage, I wonder what slippage
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cost of a non-liquid stock options are going
to be?
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Let's take a look at an example.
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In this example, we鈥檙e going to use Nike
which is ticker symbol NKE.
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Nike is a big-name security and you can see
at the time of this video, it had about a
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million shares of its underlying stock traded
that day and the bid ask spread is much wider
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in Nike than it is in Apple or SPY, almost
ten times wider.
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You can see that the at the money puts were
trading about a $.10 bid ask spread and then
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on the at the money calls, we were looking
at about a $.12 bid ask spread.
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Here's how the math works out on Nike with
this higher bid ask spread.
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We have the $.10 bid ask spread differential,
times the 100 contract multiplier, times just
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one contract on two sides because you have
to open and close the trade.
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That means that with Nike, you鈥檙e losing
$20 per trade in this bid ask spread differential.
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Every single time that we trade just one single
option contract in Nike, we鈥檙e losing $20
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to slippage.
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Talk about starting out in a whole, right?
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You wonder why most traders don鈥檛 ever make
money in this business.
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I mean, this is one of the key points here
that most people get wrong, is this ability
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to trade liquid products.
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Here's the thing.
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If we traded Nike just one time each month
for a year, we would lose $240 in total.
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That鈥檚 one stock and 12 trades.
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But wait.
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It gets better because there are stocks out
there like AVB which people will undoubtedly
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trade.
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You can see that the open interest is not
nearly as much as Apple and SPY, but there鈥檚
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definitely a market for AVB options.
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You can see that the stock has much less volume
on the underlying shares and the bid ask spread
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can be anywhere between $.40 and $.50 wide.
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Here's how the math works out on AVB.
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The $.40 bid ask spread, (just taking the
most conservative approach here) times the
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100 contract multiplier, times one contract,
times two sides to get in and out, you鈥檙e
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losing $80 per trade.
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$80 per trade just due to the wide bid ask
spread.
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This is truly insanity.
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If we traded AVB just one time each month
for a year, we would lose $960 in total.
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This is just trading one particular stock
that has really bad liquidity.
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I鈥檓 sure by now, you鈥檙e starting to see
how important liquidity is to professional
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traders and it should be to you if you want
to be successful trading options.
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But let鈥檚 take this one step further.
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Let's assume that you are slightly more active
than just making 12 trades a year.
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If you鈥檙e like most options traders, you鈥檙e
likely making four to five trades a week and
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spreads of course.
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You鈥檙e trading credit spreads and debit
spreads and iron condors and you鈥檙e trading
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strangles and straddles.
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You鈥檙e not just trading one option.
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Let's just use some average bid ask spread
that鈥檚 out there around $.20 which I think
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is more than reasonable.
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We could probably even argue that the average
bid ask spread is much higher than that.
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Let鈥檚 use a $.20 bid ask spread, times 100
multiplier for the contract, times two contracts
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if you鈥檙e trading just a credit spread or
a debit spread, times two sides to the trade
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because you have to get in and out of that
trade, times four trades a week, times 12
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months out of the year and you end up with
a total cost of $3,840.
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Congratulations!
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If you're the average investor with an account
size of approximately $10,000, you just lost
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38% of your account due to slippage cost of
trading illiquid options alone.
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I鈥檒l just let that sink in there for a second,
just how much it would cost you as a new trader
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or even a trader that鈥檚 been in this business
for a long time.
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Liquidity is a huge component to your ability
to be successful.
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As you can see, even if your broker was charging
you $10 per contract or $20 per contract,
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it wouldn鈥檛 come close to the invisible
cost of slippage that drains your portfolio.
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The good news is that you now have the knowledge
to completely avoid this.
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Because trading liquid underlying stocks is
at the heart of any successful options trading
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system including ours, you now can go out
there and look for securities that have amazing
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liquidity.
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But if you don't have the time to do that
or if you don鈥檛 want to do that, we do offer
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a copy of our own prescreened and pre-scrubbed
watch list that you can purchase.
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If you're interested in purchasing a lifetime
pass to our watch list of the top 50 plus
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liquid stocks with options that we trade,
just click the link below this video and you'll
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be taken to our website at Option Alpha.
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Once you have a lifetime pass to this watch
list, we send out an update to everyone who's
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ever purchases before in the past, letting
you know if stocks seem to have better liquidity
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or less liquidity every single month.
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We will always update this watch list as new
stocks come in and as current stocks fall
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out of favor with the market and with liquidity.
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As always, I hope you guys really enjoy this
video.
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If you found this video incredibly helpful,
please share it online, on Facebook, on Twitter,
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on YouTube.
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Help spread the word about what we鈥檙e trying
to do here at Option Alpha.
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As always, if you guys have any comments,
please ask them right below in the comment
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section to this page.
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Until next time, happy trading!
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