Picking The Wrong Stock Is Costing You $3,840 Per Year (Bid Ask Spread)

Picking The Wrong Stock Is Costing You $3,840 Per Year (Bid Ask Spread)

January 25, 2020 2 By Luis Garrison


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