{"id":18642,"date":"2021-07-05T07:30:15","date_gmt":"2021-07-05T11:30:15","guid":{"rendered":"https:\/\/www.jeffclarktrader.com\/?p=18642"},"modified":"2021-07-05T07:30:15","modified_gmt":"2021-07-05T11:30:15","slug":"this-mistake-could-cost-you-2","status":"publish","type":"post","link":"https:\/\/jeffclarktrader.com\/market-minute\/this-mistake-could-cost-you-2\/","title":{"rendered":"This Mistake Could Cost You"},"content":{"rendered":"

By Jeff Clark, editor, Market Minute<\/em><\/strong><\/p>\n

Trading illiquid options is a lot like trying to win an argument with my wife.<\/p>\n

At best, I only stand about a 40% chance of being right. And even if I win the argument, I’m going to suffer for it anyway.<\/p>\n

Let me explain…<\/p>\n

The only thing worse than being wrong on an option trade is being right, but taking a loss anyway because you can’t get out of the position.<\/p>\n

Illiquid options are options that are difficult to trade in and out of at a reasonable price. Sometimes it’s a result of too few contracts being available for trading. But usually, it’s evident by a large “spread” between the bid<\/a> and ask prices<\/a>.(For a refresher on the difference between bid and ask prices, reread my Market Minute<\/em> essay about it, here<\/a>.)<\/p>\n

That’s the problem with illiquid options. Even if you somehow manage to get into a trade at a reasonable price, it’s nearly impossible to get out of it.<\/p>\n

Here’s an example of a trade I made a while back…<\/p>\n

In early April 2016, I liked the chart of small-cap biotechnology firm Tetraphase Pharmaceuticals (TTPH). The stock had fallen 95% from its high the previous July.<\/p>\n

But after a three-month consolidation period, TTPH had turned higher. It was trading above both its 9-day exponential moving average<\/a> (EMA) and its 50-day moving average<\/a> (MA). And, its 9-day EMA had just completed a “bullish<\/a> cross” above the 50-day MA. That often signals the start of at least a short-term rally.<\/p>\n

So, I started looking for a low-risk way to trade Tetraphase.<\/p>\n

With the stock trading for about $5 per share, I wanted to sell the TTPH May 20 $5 uncovered put options<\/a>. In other words, rather than buying the stock outright for $5 per share, I could sell the TTPH May 20 $5 uncovered puts and get paid upfront for simply agreeing to buy TTPH for $5 per share if it closed below that level on May 20 (option expiration day).<\/p>\n

There was one problem… TTPH options were illiquid.<\/p>\n

There was a huge spread between the bid and ask prices for the options. The TTPH May 20 $5 puts were bidding at $0.30 while being offered at more than $2. That’s not a liquid market.<\/p>\n

Liquid options usually trade with no more than a $0.10 difference between the bid and ask prices. That makes it easy to move in and out of positions.<\/p>\n

With such a wide spread between the bid and ask prices in the TTPH options, I knew this wasn’t going to be an easy position to trade. Nonetheless, I was confident enough in the setup on the chart that I thought I could still trade the TTPH options profitably.<\/p>\n

I figured fair value for the TTPH May 20 $5 puts was somewhere around $1. So I put in an order to sell the options for $1.05. I did this for six straight days while the price of the stock went nowhere. Finally, on the sixth day, I was able to sell 10 TTPH May 20 $5 put options for $1.05 – with the stock trading at $4.95. That seemed like a good deal.<\/p>\n

Right away, the trade went in my favor. Tetraphase pushed higher. By late April, the stock had rallied to about $5.80 per share.<\/p>\n

By my calculations, the TTPH May 20 $5 puts should have been worth about $0.25 at that point. But the best quote in the market was a $0.20 bid by a $1.20 ask.<\/p>\n\n\n\n
\n

Free Trading Resources<\/strong><\/p>\n

Have you checked out Jeff’s free trading resources on his website? It contains a selection of special reports, training videos, and a full trading glossary to help kickstart your trading career \u2013 at zero cost to you. Just click here<\/a> to check it out.<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n

In other words, if I wanted out of the trade immediately, I would have to buy the options back at the lowest price offered ($1.20). So even though I was right on the trade and TTPH had moved higher, it would have cost me $0.15 more than I paid to buy the puts back and close the trade.<\/p>\n

I decided to be patient and try to negotiate a better price to get out of the trade. I entered an order to buy back the puts for $0.35.<\/p>\n

As I said above, I had calculated the fair value of the puts at $0.25. But since I had sold the options for $1.05, and had a decent profit on the table, I was willing to pay a little more than fair value to close the trade.<\/p>\n

Nobody else was willing to take my bid, though. For five days, I offered to pay more than fair value to buy back the TTPH options and close my trade.<\/p>\n

But no one wanted to trade with me at that price. There just weren’t enough traders in the TTPH options to create an efficient market. Even though I was willing to pay more than fair value to buy the options back, nobody was willing to sell them to me at a reasonable price.<\/p>\n

So, I kept the trade open a while longer. And that’s when I got into trouble.<\/p>\n

Soon, Tetraphase started to fall along with the broad stock market. The decline was slow and methodical at first. It wasn’t anything to get alarmed about.<\/p>\n

The stock was still trading above $5 per share. If it closed that way on May 20, the TTPH May 20 $5 puts would expire worthless. And the market makers would be wishing they had sold them to me for $0.35.<\/p>\n

But the stock kept falling. Tetraphase dropped almost 20% and closed at less than $3.50 per share. The May 20 $5 put options that I had sold for $1.05 were now being offered at $1.70. In other words, what should have been a profitable trade had become a loser. And it’s all because I could not get out of the trade earlier at a reasonable price.<\/p>\n

Just to be clear… At one point, Tetraphase rallied 20% higher after I sold the uncovered put options on the stock. My calculation of the fair value of the options declined by 75%. So I was 100% correct on my bullish trade on the stock.<\/p>\n

But I could not exit the position when I wanted to because the options were not liquid enough to allow me to do so at a reasonable price.<\/p>\n

So I was sitting on a losing position and kicking myself because I knew better.<\/p>\n

No matter how good the trade setup looks, it’s foolish to trade illiquid options. <\/strong>It’s hard to get into the trade… and even harder to get out of it.<\/p>\n

I originally opened the trade in anticipation of holding the position through option expiration and having it expire worthless. But once the stock started
to turn lower, I changed my mind and wanted to exit the position and lock in my profit.<\/p>\n

Let this be a lesson to you…<\/p>\n

If an option trades with more than a $0.10 spread between the bid and ask prices, find another way to trade the position – either another option with a different strike price or expiration month… or just trade the stock itself.<\/p>\n

Illiquid options eliminate your flexibility and your ability to adjust your plan according to market action.<\/p>\n

Otherwise, you might find yourself in a situation when you’re right on the trade, but end up suffering a loss anyway.<\/p>\n

Best regards and good trading,<\/p>\n

\"signature\"<\/p>\n

Jeff Clark<\/p>\n","protected":false},"excerpt":{"rendered":"

This got me in trouble…<\/p>\n","protected":false},"author":49,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"ep_exclude_from_search":false,"service":"","footnotes":""},"categories":[1],"tags":[],"publication":[10],"person":[7],"newsletter-type":[],"ticker":[],"class_list":["post-18642","post","type-post","status-publish","format-standard","hentry","category-market-minute","publication-market-minute","person-jeff-clark"],"acf":[],"_links":{"self":[{"href":"https:\/\/jeffclarktrader.com\/market-minute\/wp-json\/wp\/v2\/posts\/18642","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/jeffclarktrader.com\/market-minute\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/jeffclarktrader.com\/market-minute\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/jeffclarktrader.com\/market-minute\/wp-json\/wp\/v2\/users\/49"}],"replies":[{"embeddable":true,"href":"https:\/\/jeffclarktrader.com\/market-minute\/wp-json\/wp\/v2\/comments?post=18642"}],"version-history":[{"count":0,"href":"https:\/\/jeffclarktrader.com\/market-minute\/wp-json\/wp\/v2\/posts\/18642\/revisions"}],"wp:attachment":[{"href":"https:\/\/jeffclarktrader.com\/market-minute\/wp-json\/wp\/v2\/media?parent=18642"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/jeffclarktrader.com\/market-minute\/wp-json\/wp\/v2\/categories?post=18642"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/jeffclarktrader.com\/market-minute\/wp-json\/wp\/v2\/tags?post=18642"},{"taxonomy":"publication","embeddable":true,"href":"https:\/\/jeffclarktrader.com\/market-minute\/wp-json\/wp\/v2\/publication?post=18642"},{"taxonomy":"person","embeddable":true,"href":"https:\/\/jeffclarktrader.com\/market-minute\/wp-json\/wp\/v2\/person?post=18642"},{"taxonomy":"newsletter-type","embeddable":true,"href":"https:\/\/jeffclarktrader.com\/market-minute\/wp-json\/wp\/v2\/newsletter-type?post=18642"},{"taxonomy":"ticker","embeddable":true,"href":"https:\/\/jeffclarktrader.com\/market-minute\/wp-json\/wp\/v2\/ticker?post=18642"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}