Wednesday, March 17, 2010

CHOP Trade

My current broker apparently does not allow CHOP to be traded on margin. Other wise I would sell all my current holding and go 200% long of CHOP if and when it triggers. However, I do not have this option. So in contemplating how I can leverage the move I anticipate in CHOP, options crossed my mind.

However, CHOP stock not to mention its options have huge bid-ask spreads. For instance, the May 10 $5.00 Call Option for CHOP has a current bid of $2.20 and ask of $2.75. That is, if I were to buy this option and then change my mind before the price changed and wanted out, I would be down 20% + commissions off the bat! ((2.75 - 2.25 - C)/2.75)) where C = commission.

Then if you factor in a negative price change it becomes even worst. Lets say you planned to exit the options if the underlying dropped by a dollar. The option mentioned above has a delta of approximately 0.95. For ever $1.00 move in the underlying the option will move up or down by roughly $0.95. And if it moves down the bid - ask spread will get worse than just 20%!

Lets say I bought the option above then the underlying price fell by $1.00 per share. The option would then have an ask of something like $1.80 ($2.75 - $0.95). However, the bid would be more like $1.26 ($1.80 * 0.70 instead of 0.80 since the spread will likely get worse) which is what your most likely going to get filled at. Then you have to factor in commission. So where as the underlying stock would have only fallen by 13.5% ((1/7.41 * 100). The option would fall by a whopping 54.2%!

Even worst, the negative effect of the bid - ask spread exists on the upside as well.

Yet, I was still contemplating going 100% long this option. I will not risk losing half my account especially since the risk/reward falls off disproportinately with the risk assumed with these illiquid options. I will just have to trade from a cash position and be happy with what ever I make.

My plan for tomorrow is to liquidate my Visa and CIT positions. Then go 100% long of CHOP if and when it triggers.

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