When options aren't the best option

By David Russell,

Shutterstock photo

Sometimes options aren't the best option. This week's activity in Mecox Lane is one such instance.

The Chinese retailer fell a stunning 39 percent Monday to close at $8.15. At one point during the session it traded as low as $7.09, more than 60 percent below the peak on its first day of trading only five weeks ago. MCOX fell another 18.4 percent yesterday to $6.65.

optionMONSTER's Heat Seeker tracking system detected call buyers stepping in Monday after the stock began to rebound in intraday trading. Most of the activity occurred over the space of less than one minute in the January 10 contracts, which priced for $0.50 to $0.75.

Some traders also purchased the December 10s for $0.20 to $0.40. There was no open interest in either strike before the trades appeared.

MCOX Given the size of Monday's drop and the buying at the bottom, it definitely looked like capitulation. Normally that kind of activity would be of interest to our readers, especially those who follow our real-time trades. We skipped this one, however, because there was a hidden problem that can cost unwary traders a pretty penny if they don't take a moment to look at the bigger picture.

In this case, the problem was liquidity. If you buy a stock and immediately sell it, you are likely to lose $0.01 or $0.02 because of the difference in the bid/ask spread. (Quite simply, you buy the stock at the "ask" and you sell it at the "bid.")

The ask price is always higher, but only by a few cents. Options trade much less frequently for a variety of reasons, including the fact that a single name can have dozens of potential contracts.

That spells less liquidity, and thus wider bid/ask spreads. For instance, you might buy a call for $0.50 and then find it's immediately worth just $0.20. So under some circumstances, this defeats the purpose of using options.

Take MCOX, which barely traded a single contract before Monday. It might climb all the way to $11, resulting in a theoretical value of at least $1 for the calls, up nicely from what the investor paid for them.

But what if liquidity returns to the non-existent levels that were typical before Monday? Those same calls might be bid for $0.60 and offered at $1.40, meaning that a trader who bought them wouldn't earn a cent from the stock rallying more than 35 percent.

It's a bit like riding a bicycle in the sand--lots of movement, but you don't go anywhere.

In a case like Monday's MCOX trade, simply buying the stock would have made much more sense. It would have provided more leverage, tighter bid ask spreads, and no loss to time decay if the stock failed to rally. (See our Education section)

(Chart courtesy of tradeMONSTER)

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Copyright © 2010 OptionMonster® Holdings, Inc. All Rights Reserved.

This article appears in: Investing Options
Referenced Stocks: MCOX

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