What You Need to Know Before Using Options on Small Cap Stocks

I rarely, if ever, discuss options in the Small Cap Investor Daily.

However, the number of questions from readers has recently picked up regarding this fast growing investment approach. And I have research analyst Andy Crowder on our team - he has over a decade of experience trading options and publishing his strategies for a select group of subscribers.

So I've decided to set some time aside to discuss options and how to use them appropriately with small cap stocks. Hopefully this will help you begin to understand that options offer endless possibilities to increase your returns in an up, down or range-bound market.

***The easiest way to search for companies that have optionable stocks is to screen for them using a stock screener like FinViz.com.

This is extremely easy and only requires 4 simple steps.

1. Click on the 'All' tab

2. Set Market Cap to "Small (under $2 billion)

3. Set Average Volume to "Over $1M"

4. Set Option/Short to "Optionable"

 

 (Click the image to enlarge)

 

Once you complete the aforementioned steps you should come up with roughly 313 companies that meet our requirements.

This first screen is a necessary part of the process when trading options on small cap stocks. That's because most small cap stocks are not optionable, meaning options are not available on the stock. If the stock is optionable it may still lack the volume necessary to make a sound and reasonable option investment.

Most importantly, this screen will save you lots and lots of time.

I suggest saving this screen for future reference so you can go back and check your list to see if your next small cap stock of choice is optionable. Thank me later, as this is a true time saver.

***The most important search criteria for finding what I call 'tradeable' options on small cap stocks - VOLUME. The reason I chose to search for small cap stocks with an average volume over 1 million shares traded is because I want liquid options. Liquidity directly translates into a reasonable bid/ask spread for options - this is critical.

The more liquid the option the tighter the bid/ask spread. This is extremely important because the bid/ask spread impacts the cost of using options. Wide bid/ask spreads eat into the potential profitability of your investment, and contribute to what is known as 'slippage'.

A real world example of how volume effects the bid/ask spread should help to clarify.

Let's use The Cheesecake Factory (Nasdaq: CAKE) and USANA Health Sciences USNA for our exampIe. I chose these two companies because they are both small cap stocks with share prices of roughly $30 a share. I want to choose two stocks with equal properties, other than volume. The impact of volume will be blatantly obvious on the bid/ask spread.

If you look at the June 30 calls for both stocks you will see the following bid/ask spread:

	Avg. Vol.	Bid Price	Ask Price
The Cheesecake Factory CAKE	1.07M	$1.35	$1.45
USANA Health Sciences USNA	97.9K	$1.70	$2.20

 

Notice the difference?

The bid/ask spread is $.10 on CAKE compared to an enormous $0.50 on USNA.

This is the reason why a tight bid/ask spread is so critical when using options as part of your investment strategy. You can rarely buy an options contract at anything other than the ask price, and you can rarely sell one at anything other than the bid, especially if the options are illiquid. It is you versus the market maker and believe me you will never win that battle. With a wide bid/ask spread you are technically underwater 10 to 30 percent or more, right from the get go. Nobody wants to make up 30 percent just to breakeven.

In conclusion, dealing with the bid/ask spread is an inevitable part of the options arena. Focus on more liquid and actively traded contracts that have smaller bid/ask spreads, rather than stocks with little to no volume and wide spreads. This is an important lesson to learn when using options as part of your investment strategy. You will save yourself many headaches and most importantly, hard-earned money.

As stated earlier, I will be back in the coming weeks with more to discuss on the wonderful world of options.