Trading Options And Foreign Stocks: When Low Trading Volume Is Not Illiquid

As usual, I am putting together my Ten Clean Energy Stocks for 2020 model portfolio for publication on January 1st or 2nd next year.As I wrote in November, expensive valuations for the US clean energy income stocks I specialize in mean that the 2020 model portfolio will contain more than the usual number of foreign stocks, and I am also planning on including a little hedging with options.

Why option strategies are now affordable

I have never included options in the model portfolio before because the commission structure did not make it cost effective for small investors to trade options.That has now changed, with leading discount brokers dropping the fixed part of the commission, and now only charging $0.65 per contract, as I discussed in November. Each option contract represents the right to buy or sell 100 shares of the underlying stock or ETF, and the strategies I use typically involve options priced at $0.25 to $3 per underlying share. For a single option priced at $1, that means that the commission to enter the contract is now 0.65% of the option price ($0.65/$100) compared to the previous 5.6% ($5.60/100). If the contract is assigned, there was previously also a stock trading commission of another $4.95 (5%) commission to consider. This is now $0.

I generally consider commissions to be affordable if they are less than 5% of my expected return on a trade. I typically sell options using covered call and cash covered put strategies, meaning the expected return is on the order of half the option price. This puts the previous commissions at about 15% of the expected return for the example trade above, but the new commissions at about 1.3%. Before, I generally only traded option contracts 10 or more at a time.

The target reader of the Ten Clean Energy Stocks model portfolio is investing $20,000 or more in the portfolio, or $2000 or more in each stock. That’s just enough to buy 100 shares of a $20 stock and enter into a single option contract on the underlying position.

So, for the first time this year, I plan to use actual dollars and numbers of shares in keeping tack of the model portfolio, starting with $20,000.

Illiquid options

The option contracts on the stocks I typically cover are far from liquid, with the buy and ask prices typically as much as $0.50 (or $50 per contract) apart. Hence, buying at the ask price or selling at the bid is generally not a good idea. I find that a limit order placed halfway between the bid and the ask will often execute immediately. The volume of contracts traded also has very little effect on the contract price, which instead tracks the share price and volatility of the underlying stock.

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Disclosure: Long CWEN/A, MIXT, VLEEF.

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