by Jea Yu


Depending on the liquidity of the underlying stock, the spreads on options trades can vary from a few pennies to several dollars. This is why it’s very important that you scope out the liquidity and volume of not just the underlying stock, but the option as well. Too many websites jump headfirst into a call option only to face sticker shock when they realize the nearest bid is $0.50 below where they just bought the call. Don’t let this happen to you. Always watch how the options trade relative to the stock for at least 15 or 20 minutes – preferably during volume periods – to see how it trades. Always jot down the delta of the option, as that will be the first clue on the core movement of the contract.

A common newbie mistake is to jump headfirst into an option and then be shocked that the trade just started off with a big deficit based on the spread alone.

Scaling In and Out

Very similar to stocks, options can be scaled in and out. If there’s an event play, it’s crucial that you do scale out as the event gets closer. If it’s a pattern play, scale out every day up to the target price area and make sure to up the trail stops. Remember that pure pattern plays lose value daily in the form of time premium. A pure daily mini pup play is good for a two-day play at best. Very rarely do you want to hold into expiration.

Pre- and Post-Market Hedging

Another pitfall by options players going into an event is the inability to lock in gains during the pre- and post-market since options markets are closed. It’s so frustrating to see an underlying stock make the favorable move in the pre- or post-market, only to lose those gains without being able to profit because options markets were still closed.

There is a way to lock or hedge your gains, as long as you have buying power to purchase the underlying stock. This technique works best with in-the-money options. Once earnings are released, you simply take the opposite side of the option with the correctly allocated share sizing. In-the-money call options are easiest since you have a delta of at least 1, which means you just match up the actual share sizes with your contracts for a hedge that locks your gains. Out-of-the-money calls are tougher since so much of that is volatility premium, which will evaporate the next morning anyway. For this reason, you never want to go into earnings with out-of-the-money options unless you are just considering it a lottery ticket, fully anticipating that they will be worthless.

If you happen to score nicely on the out-of-the-money call, then you can hedge your gains once the call gets in-the-money, forming a 1 delta. Then short the same number of shares as your contracts (remember that one contract is 100 shares) in the post-market to hedge your gain. Make sure you have a gain first. Make sure your out-of-the-money options turn in-the-money before you hedge! For example, if you bought ten July 15 calls of ABC for $0.10 to hold for a gamble trade on an earnings release, you would need to wait for ABC to get up through $15.10 before even considering a hedge ($15 is the strike price, plus your cost of $0.10). Let’s say ABC pops to $16.10 post-market. You would then short 1000 shares at $16.10 while holding the July 15 calls into the market open. Regardless of what ABC does, you are locked in for a 1 point x 10 contracts (1000 shares) gain. If ABC tanks to $15, then your option would be worthless, but your stock short is worth $1 x 1000 shares. If ABC ramps to $17, your call options would be worth $2,000, while your stock short loses $1,000, still netting you the $1,000 profit. Nice trick! One more thing – when you exit the positions, try to do so simultaneously when spreads tighten and action slows down. You don’t want to give back too much of your profit from slippage and closing out the positions.