In January a variety of strategies were tested to determine if a retail trader could capitalize on seasonal trends in implied [IV] that appeared in Cisco Systems, Inc. (CSCO). An initial review of trade data failed to reveal a reliable approach. Although moves in IV were consistent, the impact of this seasonality seemed to be eaten away by the bid-ask spread. A similar potential issue was also identified when evaluating IV median reversion strategies.
In order to determine the impact, if any, of the bid-ask spread on option trading strategies, a more detailed look at spreads will be completed this week and next. One of two approaches can be taken depending on the results:
The worst-case scenario is for the review to show the impact is inconsistent, which leaves no potential for improvements via adjustment(s).
A handful of stocks and exchange traded funds [ETFs] went to penny increment quotes in January of this year. Typically a smaller group of securities will be part of a pilot program when such changes are made so that any potential systems bugs can be resolved prior to a broader roll-out. The following securities were part of the penny increment pilot program:
* Registered names.
Although options for other underlying securities may trade in penny increments as a result of price improvement from a specific market, the focus of this review is on the quoted spread. Even if a trader can typically rely on obtaining executions between the spread, it cannot be built in as a guarantee when backtesting a system.
Advanced Micro Devices
After reviewing the stocks in the pilot program, Advanced Micro Devices, Inc. (AMD) was selected for analysis. This semiconductor stock appears to exhibit some IV spikes around earnings which may be enhanced by the monthly Book-to-Bill ratio report for the industry. In addition, options have been available for AMD for an extended period of time allowing a review of bid-ask spreads prior to decimalization.
In order to gain some insight on AMD price movement and changes in volatility, four Optionetics Platinum charts are provided for review.
Figure 1: Price Chart for AMDâ6 Years
Figure 2: Statistical Volatility Chart for AMDâ6 Years
Figure 3: Implied Volatility Chart for AMDâ6 Years
Figure 4: Implied Volatility Chart for AMDâ2 Years
In early January 2000, AMD was trading at 30. A next month (44 days to expiration) at-the-money call option was quoted at 3.875 x 4.000âa $0.125 spread which represented 3% of the ask price for option buyers (0.125 / 4). A little more than a year later when decimalization was in place, AMD was trading at 25.10 and a next month (44 days to expiration) at-the-money call option was quoted at 2.75 x 3.00âa $0.25 spread which represented 8% of the asset value for option buyers. Not a good trend.
A few years later (2004) the at-the-money call was quoted at $0.80 x $0.85âwith a 6% spread. So was the reduction in the spread for this similarly liquid contract (14,000+ open interest) due to reduced IV, more competition across exchanges, a longer term to see the benefits of decimalization, or something else? In order to better answer this, a more comprehensive look at AMD option data will be completed for next week.
Slippage is a commonly referred to cost of trading that may or may not be included as part of a trading system. Commissions and taxes are the two other significant costs a trader must consider as part of a system review. Until recently, option slippage was significant due to the $0.05 and $0.10 quote increments required by the market. Now with penny increment quotes, the trader can expect narrowing spreads for liquid options and re-examine previously abandoned strategies that suffered from the wider spreads.
To see the other articles by this author, please click here.
Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site