Lesson Overview

Liquidity & Pricing Requirements

After you select a company that you want to make an earnings trade on it's important to have a set of guidelines to use for both liquidity requirements and possible premium pricing.

Here are 3 different examples of socks that have great liquidity at strike prices we want to trade as well as some tips on how much premium you should collect as a percent of the expected move.

A goal rule of thumb (if you can get it) is to collect at least 20% of the expected move in premium or credit. So if the stock’s expected move is $1.00 in either direction then if you can collect $0.20 selling options you’ll be getting a very rich premium which is great.

More Discussion

Was This Helpful? Add Comments/Questions

  • Gregory Corrado

    Perfect answer to my question about pricing! Thanks!

  • Evo

    LENNAR would be okay for a straddle strategy…yes? You would collect more than %20 of the expected move in premium.

  • Yeah I think it’s better to pass on these low IV trades – the premium just isn’t there.

  • I might just take time to get to the next level and some experience to prove to them you can handle the next step of strategies. This podcast we did on approval levels might help also since we talked to a couple brokers before publishing it: https://optionalpha.com/options-approval-levels-19297.html

    • John Mascaro

      OK thank you Kirk for the links I’ll read and watch those immediately! I’ll also keep moving forward with my goal to get to higher trading levels to manage my own account as I see that as a great next step for me to combine my existing financial background as a CPA (NY/FL) and move into a more rewarding career!

    • John Mascaro

      PS UPDATE: Kirk, I listened to your great podcast on options approval levels thanks! Of the various brokers I have now talked to and applied with – one firm I just spoke with, OptionsHouse, has approved me to trade “all spreads and basic calls & puts” appearing on their pop up screen when executing trades (debit/credit spreads, verticals, diagonals, butterflies & condors (including Iron), calendars etc. Just not naked puts/calls. They have a great platform too with great analysis tools etc. My issue is that, for purposes of analysis & execution, I have become familiar with the dough.com platform and of course TOS. You would agree I presume that I should take advantage of the approval level and go forward with OtionsHouse right? After all, I can continue to study your GREAT material at OPTIONS ALPHA, use the content & tools here, but ultimately place the trade via OptionsHouse, right? That allows me to start trading the more efficient/probable strategies rather than biding my time – would you agree?

      • I would move forward for the time being because you could leverage the trading approval there later on when you apply someplace else.

  • Generally a good rule for strangles but yes iron condors are harder to hit this target since you have to buy protection (though you could buy wide wings)

  • Yep agreed, liquidity is a big consideration because we want to reduce slippage as much as possible. Also the founders of TOS also started a new brokerage, TastyWorks which has $1 commissions for everyone – check it out.

  • Paul

    Hi Kirk, thanks again for all these great videos. I have a question about pricing for risk-defined strategies on earnings trades like iron condors. Would we apply the same pricing requirements that you outline in your other videos (i.e., probability ITM multiplied by size of your spread). If so, I find that this pricing requirement is really hard to hit, even with super high IV on the underlying. However, I’m wondering if sacrificing a few dollars on premium to potentially make money overnight on an earnings trade is worth the additional cost. What do you think?

    • Yep it’s okay not to hit the optimal as long as you can get close.

Show Video Transcript +

In this video tutorial, I want to talk about some liquidity and pricing requirements as it relates to earnings trades. We’re just talking about earnings trades. These are those one-day events where we’re trying to take advantage of that IV drop or that IV crush that happens.

I want to go over a couple of different examples tonight to show you what really good liquidity and pricing looks like and then also a couple of examples of what bad liquidity and pricing looks like.

We’re going to start off tonight with actually SLB because we’re making this trade right now. This is a live trade that we just made at the time of this recording which was January 15th, and I don’t know if it’s going to be a winner or not, but it’s a live trade, and I want to show it to you because we’re trying to put our money where our mouth is here.

Exactly what we preach to you guys and what we tell you and what we coach is exactly what we do. And you can see, we have this little position tags right in here inside the video platform here, so you can see that these are live positions that we already have, these aren’t working orders of some kind.

What I always say about option liquidity is that first, we want to see option depth. What option depth means is that there is a lot of depth in the underlying across a bunch of different strikes.

We want to see a lot of liquidity across a bunch of different strikes; there’s no one strike that dominates. You can see on SLV here both in volume and open interest on both sides of the market, there's a lot of liquidity and a lot of depth, meaning that there’s a lot of activity at every single strike that it has.

Now, some options have more activity, and those are the ones that are closer to the money, and they’ve got a little bit more activity than others, but in general terms, there’s a lot of depth and liquidity in the market, and you can see it’s pretty evident especially with some of the contracts that we are dealing with have a lot more liquidity and volume today.

That was part of the reason that we chose them though it’s not everything. The other thing that we talk about is pricing requirements. Pricing is something that's not set in stone; there are no hard and fast guidelines for them.

What we do like to see is we do like to see us getting outside of the expected move which in this case for SLB, this was $3.34, that's the expected move that it should be making or somewhere inside that range up or down and we like to price our strategies and select strike prices that are just outside of that expected move.

We can always get outside of that expected move, but then the question becomes, “Are we getting enough premium to make the trade worthwhile?” A good rule of thumb is that you want to try to collect about 20% or more of the expected move.

You want to collect about 20% or more of this $3.34, and if you can do that, that’s just a good rule of thumb, it’s not going to say that you’re going to make more money or less money, it’s just a good rule of thumb, some road marker or guidepost to use as you’re collecting premium.

But at the same time, if you’re only collecting $.10 or $.12, not enough to cover commissions, it's probably not worth doing the trade. In this case, we collected about $1.9 in the trade from where we ended up making the trade, not from where it’s trading right now.

But we ended up collecting about $1.9 in the trade or about $109, so it ended up being a pretty good trade. That also moved our breakeven points out another dollar on either end from 80 to 81 on the topside and 73 to 72 on the bottom side.

A really good example here of great liquidity in the underlying market and a really good pricing as well. The other one that we want to look at is Intel. You can see with Intel… I’m sorry, let me just go back real quick and then I’m jumping back and forth.

The other thing is that we collected about $1.9 in premium, so $1.9 divided by the expected move which is $3.34 means that our premium was about 32.6% of the expected move. Just to round out what we talked about before, trying to collect around 20% of the expected move is what you’re looking for.

The other trade that we got into today… Again, we go into this trade today, this is Intel, and you can see this is true trades by our position here.

Instead of doing a strangle in this case, we did a straddle, and we liked to get outside of that expected move which is about $1.5, so $1.52 is the expected move, that’s what we’re trying to do.

We did so with our iron condor and collected $.43 which is obviously more than that 20% threshold of the expected move, so pricing wise, it was pretty good. What I love about Intel and why I’m going over this in this video is that it has a ton of liquidity and you can see just how liquid these markets were.

In fact, the pricing at the strike that we selected here, the short strike at 37 was about a two penny wide market. You can see the bid-ask spread in this market was incredibly tight, and this is a really good thing, and this is something that people gloss over, is this idea of liquidity.

But as I’ll show you later, if you don’t take notice of liquidity now, it can create huge slippage cost in your trades later. And slippage is not something you feel, you don’t feel the effects of slippage, but it's something that can dramatically affect your profit and loss at the end of the year without even knowing it.

You can make great trades, high probability of success, but if there's lack of liquidity in the markets and you have incredibly wide bid ask spreads, it creates tough slippage to get around.

And the same thing on the other side, you can see that these markets are pretty tight, they widened out overnight right now, but they were pretty tight today, they were around three pennies today and about four pennies here at about 34 strikes.

You can see lots of liquidity, this is a very active market, 23,000 contracts, 26,000 contracts traded and you’ll notice that we tried to stay where most of the contracts were traded.

That just allowed us to get in and out of the market very, very quickly and on the call side, we stayed right around where the vast majority of the contracts were traded because that was a great area to trade and it was outside of this expected move that we were looking at, so a really, really good example with Intel and super, super liquidity.

Alright, let’s look at a couple that maybe are not so good. This one is Lennar; this is LEN. Lennar has decent liquidity, so it meets the requirement for liquidity.

There’s a lot of activity here for sure, there’s a lot of things going on, you can see that the at the money strikes have a lot of liquidity and the markets are very deep and wide, but the problem with Lennar is that you just can’t get enough premium to really make this trade worthwhile.

The expected move is about $1.23, and from where the stock closed, it means you’d have to get at least somewhere under 42.5 really to say the least and to make it worthwhile.

You're looking at about 41.5/41 as far as an expected move lower and selling premium for just $.13 which is what the 41 strikes would be or to sell premium above the market for about $.11 at the 44 strikes, it gets you outside of that expected move, but you’re not taking in enough premium to make the trade worthwhile.

Hopefully that is a clear example. The liquidity in Lennar is okay, the liquidity is fine, but when you look at the premium that you’re receiving, you’re just not receiving enough premium to make the trade worthwhile.

You're capturing enough premium close to a 20% capture rate on the expected move, but it just doesn't make sense enough to cover a lot of the commissions that you’d have to deal with.

Alright, the other one that we wanted to look at was PNC, I believe. PNC is another firm that is announcing earnings tomorrow. We did not trade this. You can see there’s no trades on here.

Again, decent liquidity in the underlying stock, there’s not bad liquidity, but it's not great liquidity at the same time. But the expected move here in PNC is about $2 and you can see you get outside of $2 and the options are worth about $.18 on an $85 stock or $.7 as you get down below the market.

It just doesn't make sense to make this type of trade because there’s just not enough premium there. Liquidity is okay and you get past that hurdle, but then when it comes to pricing and premium that you’re receiving, there’s just nothing there to really be had, so you got to scratch that one off.

Some of the other ones that are out there… I think one of the ones that we want to look at is BRID, I believe. No, which one is it. Hold on one second. It’s BRID or WIT. Okay, this is another one that has earnings.

I’m sorry, it was WIT. This is another one that has earnings that are being announced tomorrow. This is probably a classic example of a stock that just has no potential chance to be traded because of look at the liquidity in this market.

This is incredibly low liquidity. I mean, practically no liquidity. You can see there’s one contract here, the 12.5s that have about 1,000 open interest in contracts, but after that, there's only one contract on both sides that was traded today.

It’s impossible to trade this thing and make a living doing it. It comes down to the fact that this liquidity… In fact, there's nobody there to trade, to begin with, but even if there was, the bid-ask spread in some of these markets is almost $45 wide.

You’re losing $45 right off the bat as soon as you get into the trade just on the bid-ask spread and the slippage and that's not something that you necessarily feel, but you can visually see it now that the bid and the ask are $45 apart.

That’s a huge, huge margin to cover and for a small retail trader like you and me, it’s just impossible to get that back. You’ve got to focus your attention when it comes to earnings trades on really high liquidity, great pricing.

It is worth your time and investment to learn how to do this right and to pick and choose the trades that are appropriate and fit those parameters because you do it the wrong way even if you're right in direction or implied volatility dropped.

You may not be able to exit, and even if you can exit in a low liquidity market, you’re going to lose a bunch of money just on the slippage.

Hopefully this is a really good example as we went through a couple of different scenarios here with wide trades that are trading right now with earnings, so the data couldn’t be more fresh and realistic and hopefully this was a great example for you.

If you have any comments or questions, please ask them right below the lesson page. Until next time, happy trading!

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