Top Five Stock Criteria for Options Trading

By all accounts, activity in Options continues to grow. Not only are Options escaping their “niche” stature as a derivative instrument due to broader exposure via media advertising, but their use is also growing due to necessity. For the average retail stock trader, many of today’s popular stocks are far too expensive to purchase. Want to buy 100 shares of GOOGL? Prepare to part with over $70,000 of your capital. Ditto for AMZN. Even buying shares of the S&P500 ETF SPY will cost you nearly $21,000 for 100 shares.

And this is precisely why retail investors are flocking to Options trading to more efficiently utilize their capital, as well as create cash-flow strategies with much lower capital requirements.  

But WHICH stocks? Most stock traders are already familiar with the daunting process of evaluating stock fundamentals to find those candidates that have the strongest growth potential, but that is just the beginning of the process when it comes to finding a good stock candidate to trade options on; some are better for options trading than others are. What specific criteria makes a stock “better” for successful options trading? Let’s take a look:

1) Be “Optionable!”

It might surprise you that not all stocks have derivative options; in fact, only about half of the available tradable US equities have listed options. As of this writing, a quick scan of the NASDAQ and NYSE exchanges shows that there is just shy of 5,000 stocks in the US market that have listed options. As we’ll see, we’re not going to trade all 5,000 of these; only a small subset of these give us the edge that options traders desire. Our number one criteria, therefore, is that our candidate stocks be “Optionable.”

2) Open Interest/Volume

Another new concept for stock traders to learn once they start to trade options….is that every option at every strike price has its own “market” with a bid and ask price, as well as associated trading volume. In the options chain listed below in Figure 1, you can see how each call option has its own daily trading volume of contracts, as well as “open interest,” which represents contracts that are currently being held.

Figure 1

Figure 1

In this particular case, there is NO volume for the calls on this stock, and the open interest with 14 calendar days left is either non-existent, or extremely low. Because of these low numbers, liquidity for these options is terrible. Note how wide the bid/ask spread is of these options, such as the 17.5 strike calls: $1.55 bid by $3.40 offer. That is a HUGE amount of edge to surrender by playing this stock.

Because of these effects, our second criteria for an optionable stock is that the Open Interest be at least in the “hundreds of contracts” scale in the near-term options. Options than are further out in time will, as a matter of course, offer less Open Interest.

3) Spread Width

Not unlike that with stocks, traders will have the best success with very narrow spreads between the bid and the ask price of the options.  In Figure 2 below, you can clearly see how the option chain below shows an extremely liquid instrument with bid-ask spreads about a penny wide….and much of this is due to the heavy volume and open interest:

Heavy open interest should drive tight bid/ask spreads, but not always….times of heavy volatility can “widen” the bid/ask spreads. Ensure that any stock that you are trading with options has the narrowest bid/ask spread possible.

Figure 2

Figure 2

4) Strike Price Granularity

This is less of an important criteria if you are starting out by just buying “long call options,” but sooner or later, you will gravitate towards safer and higher-probability “spread” strategies. And when you do, you will want to “fine tune” your spread positions by not only location on the options chain, but also by the width of the spread itself, being the difference between the strike prices. With most retail traders learning on smaller accounts, this takes more precedence that you are able to fine-tune the position risk to meet the capital requirements of your account.

Compare the strike price “granularity” between the chains in Figure 1 and Figure 2 above; clearly the chain in Figure 2 offers much more granularity of strike price offerings, increasing its flexibility to be used with any-sized account.

5) Weekly Options

All optionable stocks offer “monthly” expirations, which are typically the Saturday following the third Friday of the month.  This is how options were first offered back in the 1970’s. Beginning in about the 2005 timeframe, however, option cycles offering Weekly expirations began to be offered, and are now enormously popular amongst active traders. Because of this popularity, stocks offering Weekly options usually (but not always) display ALL of the characteristics that we’ve looked for up to this point, which include listed options, open interest/volume, tight spreads, and good granularity. As of this writing, there are 436 available stocks that offer Weekly options, or about 9% of the available optionable stocks. Your best opportunity for a consistent, profitable experience is therefore with a stock featuring listed Weekly options.

Summary

The average retail stock trader who migrates over to trading options….will usually go through this learning cycle before they learn how important LIQUIDITY is to options trading success. There is no more frustrating experience than to get everything else correct on a trade setup, but being unable to exit the trade for your earned profit because there is no one else on the “other side” of that option to let you to close the trade.
At TheoTrade, we insist on strong liquidity before we trade any options, and offer all of our members a “scrubbed” watchlist of highly liquid stocks that meet all five of our required criteria.

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1 Comment

  • Ryszard

    June 13, 2016

    Yep, great checklist, Doc, thanks.