From the April 01, 2007 issue of Futures Magazine • Subscribe!

Trading Penny-priced options

Penny-priced options, introduced October 2006, are gaining acceptance. Currently all exchanges support penny priced increments on 10 stocks and three ETFs. However, some firms, such as Interactive Brokers (IB), support penny-priced increments on just about all options. Here, the penny increment trade must be executed between IB clients or via a price improvement exchange such as the Boston Options Exchange or the International Securities Exchange.

With nickel increments, an option’s bid/ask might be $2.10 to $2.15 and the buyer’s only recourse would be to pay $2.15. With penny options, the bid/ask will be tighter, for example $2.11 to $2.14, which benefits buyers and sellers. With penny options, the buyer also could enter a limit bid of $2.13 in an attempt to get a better price. Many more trades are possible with penny-priced options.

Pennies On Expiration Friday

Here is a “one-day” penny-option strategy using the lowest penny option increment. It was executed on Feb. 14, 2007 (expiration Friday) using Microsoft (MSFT) put and call options. With MSFT trading at $28.70, penny-options prices allowed a trade to be made (see “Count every penny”).

For MSFT to close at either $30 or $27.50, the stock price would have to move by about 4%. Looking at historical pricing data for MSFT going back to 2000, MSFT’s stock changes less than 4% in a day 95% of the time. Therefore, based only on historical data, the success factor of a position depending on a less than 4% change in the price of MSFT in one day is 95%.

The strategy is to sell the MSFT 30 call and the MSFT 27.5 put options each for 1¢ and with a trailing stop order on each for 4¢. Thus, the risk/reward is 4/1. The goal is that the options sold will expire worthless at the end of the trading day (expiration Friday). This trade would not have been possible using nickel increments as there were no buyers of these options at 5¢.

For this trade, 200 put options at 1¢ were sold ($200 minus $50 commission). The same number of MSFT call options were also sold.

With today’s deep discount brokers, commissions to trade an option can be as little as 25¢.

An equation to evaluate this type of trade is:

Trade Merit = chance of success * reward – chance of failure * risk

For a favorable trade, “merit” must be positive and the larger the merit number, the better. For this trade, the merit was very high and the trade was successful:

Merit = .95*1 - (.05*4) = + .75

Even though this trade has a trailing stop order, it is selling options naked and therefore requires considerable margin. This strategy is best suited

for accounts that have excess margin on expiration Friday.

One caveat is that for a drop of something like 3%, it is assumed that the stop will not be executed because there are only hours left in the trading day. However, this is not known.

Credit Spread for Pennies

Another potential opportunity provided by penny pricing involves credit spreads. On Feb. 23, MSFT stock was trading around $29 per share with the bid/ask of the March 25 put at 1¢/2¢ and the March 27.5 put at 6¢/7¢ with expiration three weeks away.

The credit spread strategy will sell the 27.5 puts and buy the 25 puts for a credit of 4¢ per contract. Because the spread is 2.5 points, margin of $250 is required per contract. Thus, for an outlay of $250 for a profit of $4, that is 1.6% per month.

While it may not sound like much, if this trade was successful every month, the profit would be 19% per year. Again, looking at historical pricing data for MSFT going back to 2000, MSFT’s stock changes less than 5% from third Friday to third Friday 72% of the time.

The merit for this trade is negative as is common for most spreads. The advantage of a spread is that margin is minimal and the spread can be closed before the worst case loss.

Tony Elenbaas and David Tsou are software engineers and independent option traders. E-mail them at elenbaas@verizon.net and dtsou@hotmail.com.

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