Got Questions About Stock Options?

By Chris Ebert

Looking for suggestions on the best way to structure an option trade on a specific stock; need a second opinion about possible hidden risks of an option; or are you a beginner in need of basic information on how to get started? This is the place to get answers.

RGR stock may present opportunities, but low liquidity makes options iffy.

Question: “If I felt RGR was going to be higher in 1-3 months from now, what would be a good option that would track the stock nicely w/o too much spread?” ~ jp

Answer: Normally, the most efficient and also least risky option trade in a case where a stock is expected to move higher is to buy in-the-money calls. Sturm Ruger & Co. (RGR) stock was trading as high as $58 several weeks ago, but has taken a big hit and is now in the $36 range. If you believed the stock had found support and was headed back up by July, buying the $30 July call options would be preferable. If the trend was expected to take longer, the $30 October calls would be more efficient. Unfortunately, neither one of those trades is likely to be executed in the real world.

The best option is not always available

RGR options are not heavily traded, sometimes as few as a dozen or so contracts per day, and as a result they are not very liquid. The bid/ask spread is fairly wide on most of the options, and the effect is even greater on those that are in-the-money. What that means is that you probably could not buy a call at the $30 strike without paying market price, and if you did manage to open the trade you might not be able to close it if the market moved against you.

The next-best option may not be good enough

The reason the in-the-money calls are preferred is that they track the stock price closely (high delta) without much loss due to either time decay (low theta) or decreasing volatility (low vega). Choosing a strike price closer to the current stock price, say $35 or $40, has the benefit of higher liquidity, but that benefit is almost sure to be overshadowed by poorer tracking. At these strikes, the stock price could go up 10% or more and you would still have a loss, whereas the $30 strike might only require a 3% increase to break even at expiration.

Making the choice

Ultimately, the choice of whether or not to trade RGR options would come down to whether the leverage they provide is worth the cost. For about $7000-$9000 it is currently possible to control $36,000 worth of stock using the $30 strike long calls, but there is no guarantee there will be a trader willing to sell them. Moving the strike price to $35 increases the probability of finding a seller at a fair price, but not without severely limiting the performance of the trade in an uptrend. Either trade will profit from a strong rally while providing protection from a sudden downturn, but a stop-loss on the stock itself could prove just as effective. Unless the increased leverage is the primary objective, the low liquidity of RGR options makes them unattractive for most individual traders.

Preparing for trouble

If you do decide to buy in-the-money calls, you need to be prepared for the possibility that they will become totally illiquid. An exit plan should be prepared in advance, to either short the underlying shares or buy in-the-money puts as a hedge, or to exercise the calls prior to expiration. In a scenario where the $30 calls were purchased and the stock rallied to $50, closing the position would be next to impossible, so an alternative plan might be the only way of exiting the trade.

Christopher Ebert, co-author of the book “Show Me Your Options!” often receives questions about options and attempts to personally answer each one. Questions may be entered in the comment box below, or sent to optionscientist@zentrader.ca. Your email address will not be published.

The above material is intended for educational purposes only and not as advice or solicitation to trade any of the instruments mentioned.  Because of differing abilities to handle risk, no single option trade can meet the needs of every trader.