Lemonade Stands and Liquidity

June is upon us, and the hot weather has sprouted young entrepreneurs in the form of lemonade stands popping-up all across the neighborhood. My boys are part of this business cycle, and are reaping the rewards of my neighbor’s loose change. One of the boys exclaimed “Dad, we are cleaning it up out there” pointing to the curb where there business venture begins each day. I didn’t have the heart to tell them the hard truth. The truth is, like all business ventures, there is a financial cost to things like; sugar, lemons, ice, and plastic cups. If I was to tell them that the first 25 cups sold, barely cover the cost of operations, they might have a change of heart. Sitting in the sun for the hottest part of the day just too breakeven doesn’t seem to have the same entrepreneurial appeal.

Options work the same way! If we choose to do business by placing calls and puts while forgetting entry and exit costs in the form of bid and ask spreads, we, like the kids on my street, may naïvely feel to exclaim, we are cleaning up! When In reality, we haven’t begun to breakeven. See the table below, notice the various cost of doing business for at-the-money options 30 days out on some popular stock’s options. Cost column indicates costs that vary between the bid and ask prices depending on their liquidity. The more the options are traded daily, the tighter the bid ask spread might be. But if one doesn’t pay attention to slippage (difference between bid and ask prices) they might be having to dig themselves out of a deep hole. As a general rule, I try to never place trades with bid/ask spreads greater than 10% of the ask price. So, if we use AAPL as an example, the ask price is $2.10, and ten percent of that price would be .21 cents. Since the bid ask difference is .04 cents, this trade would be fine. Looking at HAE, the costs are 70% which is too great to incur and we would be best to go elsewhere.

Stock Bid Ask Cost
AAPL 2.06 2.10 1.9%
AMZN 17.65 18.20 3.0%
SPY 2.31 2.35 1.7%
HAE 2.00 6.70 70%

So, enjoy the summer and remember, costs are costs, and keeping costs low is always good business. Trading stocks that have high option liquidity and low costs is good business.