Tuesday, April 7, 2015

Trade often or trade strategic? You decide!

So I've "grown up" trading options by listening to segments on TastyTrades and trying strategies out for myself. Their main strategy is selling premium (buy into weakness, sell into strength) through spreads.

This strategy, while beneficial in some aspects, gets rather expensive. With any study, one must take into consideration the impact of commissions. I've been informed by TastyTrades research team that all studies P/L are post commissions. This is a good thing but the consideration of contract size is also very important.

Here are the fee structures of some of the brokerages:



TD Ameritrade TD Ameritrade (alternate) OptionsHouse OptionsHouse (alternate) Interactive Brokers
Ticket Fee $9.99 $0.00 $4.95 $0.00 $0.00
Contract Fee $0.75 $1.50 $0.50 $1.00 $1.00


TD Ameritrade's alternate fee structure is from their Dough.com promotion. OptionsHouse also advertises an alternate 5 for $5 deal on options and $1 for contracts over 5. Interactive Brokers (IBKR) lists their price at $0.70/contract but the hidden fees make the actual total to be greater than that of $1.00.

Now why does this matter? Well... If you sample enough you will find that all things tend to look like the Normal Distribution. So if you exercise a winning strategy over the long run on many plays you will be profitable (incrementally). This sounds great on paper if things were commission free but in the real world you have to deal with commissions and taxes.

Looking at TD Ameritrade first we have the following graph:

Note: All transactions are round trip (i.e. buy to open and sell to close on x number of contracts). Comparisons are done at a $1.00 profit per contract (unity) to make the numbers readily comparable between brokerages.



Y-axis is Profit/Commission 
Breakeven point at 13-14 contracts for TDA.

If you are doing less than 14 contracts on spreads or less you are essentially being squeezed out of your profits by commission. Around 20 contracts is the point of inflection, 40 is where the hurt starts to level off and it gets better after 60 contracts (round trip).

If you trade small (sub 14 contract) then the $1.5/contract makes sense from TDA but if you are doing spreads with 14 contract size it is a whole lot better to have the $9.99 + $0.75/contract program.

Now let's compare this to OptionsHouse:



Breakeven point at 10 contracts for OptionsHouse.

Obviously, with a cheaper rate, OptionsHouse is more profitable for the trader who trades more than 10 contracts. Ideally, more than 40 contracts is good and 100 is great in terms of 'cost-savings.' Since IBKR has the same commissions as Options House at $1.00 a separate chart is not necessary.

Notice that the profit/commission at 40 contracts is 50 for TDA and 80 for OptionsHouse which is a 60% larger profit to commissions ratio.

Moral of the story is to trade smart in terms of size and always take commission into the equation. No matter if you win or lose the house will always win on commissions. If you win, you want to minimize your expenses and if you lose you want to reduce further pains from selling.

Long-term LEAPs strategists would live ideally in the 80-100 contract range while the trade often trade a lot strategist would live in the sub 10 contract (5/5 or 10 singles) range.

Since people trading options understand the Greeks, perhaps an appropriate letter for this discussion is Omega (Ω). Omega is the cost of exercising strategies as a function of the number of contracts. We haven't even addressed the issue of assignment/exercise fees which is $19.99 for TDA, $4.95 for OptionsHouse, and FREE for IBKR. Strategies involving spreads always face the risk of assignment and those going long might want to exercise some of their options. Always account for the expenses.

Bottomline: TDA's $1.50 promotion through Dough.com only makes sense if you trade sub-13/14 contracts roundtrip. If you trade any higher than that switch to the ticket and contract fee structure. Make your own comparisons on strategies you want to implement and the Brokerage of your choice. Aside from fees, look at the SEC Rule 606 on the brokerages on how and who clear/routes their orders and pay close attention to the %s for each category of order type.

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