Assume a Frictionless Market

Two economists find themselves at the bottom of a deep hole. "How do we get out of here?", one economist asks the other. "Assume a ladder", the other economist replies.

The truth here being that economists are often to prone to making assumptions that have little or no bearing on reality. Well, a lot of my lesson material here does as well and it's best that you keep that in mind.

Whenever I discuss an options trade or strategy I assume a frictionless market. What do I mean by that? I take no account of commissions. I do not factor in the bid/ask spread. I assume money can be borrowed or loaned at the same rate. I assume complete liquidity that allows for ease of entry and exit. I do not consider tax consequences.

This is obviously not the case, yet I must teach this way. I have no way of knowing your commission structure. I only recommend trading options that are highly liquid with a tight spread between bid and offer. I advise using only limit orders and not market orders (see my column on April 12 for a discussion of order types) so as to eliminate "slippage", meaning getting filled at an unexpected price. I do not know your cost of money, nor do I know your tax bracket.

Does this make my lessons completely detached from reality? Well, I certainly hope not. Basically, what I am trying to do is teach you a way of thinking about and understanding options and their working theory and method. Remember, I do not advise or recommend any particular trade or strategy. I illustrate and educate.

Just keep in mind my assumptions and remember that I am not your financial adviser, I am your financial educator with an emphasis on simplifying, explaining and demystifying exchange traded options.