Thursday, March 19, 2009

Stock Option Friction

Stock options are often demonized as recklessly risky investments. Others tout options as useful tools for managing risk in a portfolio. An aspect of stock options that isn’t discussed much is the frictional costs of commissions and spreads in stock option investing.

The people I have known personally who have dabbled in stock options have been burnt badly. They approached options with a gambler’s mentality and lost. This is enough to justify the advice many give to stay away from options unless you are an expert or are getting advice from an expert.

On the other hand, if used correctly, stock options can reduce the overall risk in a portfolio. There is no free lunch, though. If the portfolio risk is lower, then the expected return is lower as well.

An aspect of stock option investing that has always concerned me is the high friction. Frictional costs are the costs associated with trading in and out of stock or option positions.

When I buy or sell stocks or ETFs, I pay a visible $10 commission. A less visible cost is the spread between the bid price and the ask price. The bid price is the highest price someone is willing to pay for the stock, and the ask price is the lowest price someone is willing to sell the stock for.

The spreads on stock options are much higher than the spreads on stocks, and stock option investing usually involves more trading than direct investing in stocks, which costs more in commissions.

An Example: RIM stock

Suppose that I wish to own 200 shares of RIM stock. As I write this, the current quote on RIM is

Bid: $52.00
Ask: $52.02

If I make a market order for RIM, I would pay the ask price. The total cost of buying 200 shares of RIM would be 200 shares times $52.02 per share plus the $10 commission for a total of $10,414.

When the time comes to sell the shares, with a market order I would get the bid price. My total frictional costs would include the two commissions plus the bid-ask spread. The two commissions cost $20 total, and the 2 cent per share spread on 200 shares would cost $4. So, the total frictional cost is $24.

Another Approach: RIM Options

As I write this, the current quote on the Montreal Exchange for September 2009 RIM options struck at $52 is

Call option:
Bid: $9.40
Ask: $10.90

Put option:
Bid: $8.70
Ask: $11.35

The first thing to observe is that the bid-ask spreads are about 100 times the spread on RIM stock. Another minor consideration is that (at my discount broker) commissions on option trades are $10 plus an extra $1.25 per option contract. A contract corresponds to 100 options.

To properly compare direct stock ownership costs to option trading costs, we’ll use what is called put-call parity. It turns out that if you own an at-the-money call option and short an at-the-money put option at the same time, it is the same as owning a share of the stock, except for a few differences I’ll discuss in a moment.

So, if we buy two call contracts and sell short two put contracts on RIM, it is about the same as owning 200 shares of RIM. If RIM shares go up, you’ll get this upside with the call contracts, and if RIM shares go down, you’ll pay for this from the shorted put contracts.

The main differences between owning the stock and taking the option approach are frictional costs, dividends, tax treatment of gains and losses, the possibility that the put option gets exercised early, and margin requirements for writing puts. But the gains and losses from movement in the stock price are the same.

Let’s look at the frictional costs of the option-based approach more closely. We’ll assume that the put option doesn’t get exercised early, and that we will close out the option position just before the options expire. If RIM stock has gone up, this means selling the call option and letting the put option expire worthless. If RIM stock has gone down, this means buying back the put option and letting the call option expire worthless.

We will be making 3 option trades with a total of 6 option contracts traded. At $10 per trade and $1.25 per option contract, this is a total commission cost of $37.50. Things get worse when we consider the spreads.

We had to pay the ask price of $10.90 (see the quotes above) on the call option, and received the bid price of $8.70 for the put option. The net cost per option is $2.20. Multiply this by the 200 options of each type, and the total spread cost is $440.

The final trade to close out the option position would have a much lower spread because options on the verge of expiring have a more predictable value. I’ll assume an additional $20 in friction to close out the option position. This brings the total frictional costs to $497.50.

So direct stock ownership costs us $24 on a roughly $10,000 investment and achieving the same thing with options costs nearly $500, or 5% of the stock investment. This is a huge expense ratio over only a 6-month period. Continuing to own the stock costs nothing more, but the option investor will pay another $500 every 6 months.

The moral here is that while options have their place for knowledgeable investors to manage risk, frictional costs can be substantial and must be taken into account.


  1. I think you are looking at a quote with a very large spread because the Montreal Exchange is not open for trading (at the time the article was written).

    The Bid/Ask spreads on issues with reasonable volumes in the US are much smaller, but again, these can really only be compared when the market is open.

  2. The points you make are correct, but you don't paint a fair picture.

    On the CBOE, the difference between the bid and ask prices for Sep 50 calls and puts is $0.15 each. That's a much prettier picture than you paint using the Canadian exchange.

    Next, if you enter a spread order to buy 2 calls and sell 2 puts, you will get a quote that is wider than the market in the stock, but which is reasonable.

    Don't ignore the fact that the stock uses more cash, and although interest rates are low, the option investor has cash on which to earn interest between now and September expiration. Of course, if the stock pays a dividend, the option owner does not collect that dividend.

    And then there's leverage. The customer who lacks the cash to buy shares can own the synthetic shares (long call, short put) for far less. Not less risk, just less cash. [To avoid being assigned early, lower strike prices make a better choice.]

    PS Do they rally have 52-strike options in Montreal?

  3. Glenn: I wrote the article midday yesterday. The Montreal exchange seemed to be open. Quotes on various options were changing. I took another look just now and the spread on puts is narrower, but calls are still wide.

    Mark: I don't doubt that option investors need to stick to a subset of available options to avoid excessive friction. Unfortunately, I've never seen a beginner's option guide (or advanced one for that matter) that discusses this problem. And yes, the Montreal exchange listed 52-strike options on RIM.

  4. Thanks Michael - for comparison purposes, the CBOE spread for RIM Sept '09 calls slightly in-the-money are between 4 and 10 cents at various strike prices (as I type) - as Mark points out, a much prettier picture. I don't know why Montreal's spread is so wide.

  5. I once looked at a study that compared covered call writing vs buy-and-hold and found that writing covered calls had better risk-adjusted returns. I didn't dig deeper but it seemed to me that the covered call writing strategy seemed to ignore all the extra real-life costs shown here.

  6. CC: I find that almost all analyses of option strategies ignore friction costs. Based on the feedback I've received so far, I think I'll repeat my analysis with CBOE premium quotes.

    Mark: I have questions about your point about interest on cash. From what I've read, brokers have margin requirements for writing options. I'm used to the term margin referring to a borrowed amount with interest charged. Based on your comments, I'm assuming that interest is not charged in the case of margin for writing options. So, if I could potentially have to shell out $10,000 to buy stock related to writing puts, and I have $6000 in cash in my account (which I think is enough margin in most cases), I'm assuming that I wouldn't be charges interest for the other $4000 (unless the put was exercised), and that I would be paid interest on the $6000 in the account. Am I correct on both halves of this question?

  7. James,

    Using your example, buying the calls requires no margin. But you must have cash to buy the call.

    Selling the put requires margin. For simplicity - the most that margin can be is the cash required to buy the stock - if assigned an exercise notice.

    But cash is not needed to meet any margin requirement. Assuming the customer account has other holdings, those will satisfy margin.

    Yes, the broker pays (almost zero) interest on cash. Interest is only available (I should have mentioned this) when that cash is deposited elsewhere - at better rates. Some brokers offer certificates of deposit to customers.

  8. Mark: Thanks for the information. I'm working on a update to this post for next week taking into account the comments from you and Glenn.

  9. Mark: I just looked back at some old brokerage statements back in 2000. Some shares were being delivered to my account and I sold them short about 3 weeks before they arrived in the account to close out the short position. I left all the cash from the sale in the account along with several other securities. My margin requirements were well covered even with just the cash. I was paid interest on the cash and was charged interest (at a higher rate) on what appears to be about 50% of the value of the shorted shares. I don't think this interest gets passed along to the owner of the shares I borrowed to short, and so I get this was just extra profit for the brokerage. My question for you is whether something similar happens with selling options short. Do option writers get charged interest on some calculated amount of margin?

  10. A few notes:
    1) entering multiple option positions results in tighter spreads and lower commissions. Some shops will do them as one transaction (10 + x per contract for the puts and the calls together). However, you may get dinged on assignment, if that happens. TD will charge over $40 for the assignment, regardless if you qualify for lowered commission rates! Many option combinations can be transacted on tighter spreads (veritcal spreads, for example) because they represent lower risk to the market maker. The wider margins on Montreal reflect liquidity (the lack thereof!). Deep in the money options will, generally, have wider spreads. You can enter/exit at a given price. DON'T use market orders, particularly on Montreal. What this means: you'll likely get filled when the stock moves enough to push your price slightly out of "value." That distance then becomes your actual spread. Montreal quotes are garbage, particularly when you'll get filled between the bid/ask regularly. It's very easy to find "quoted" spreads you could drive a truck through on Montreal. Get out the option calculator, figure the fair price, give the market maker a bit to play with, get filled... and no where near the quoted "naturals."
    2) Interest is not paid on margin, only on cash borrowed. Example: selling the put results X dollars of margin required. If the account has more than X in available margin due to other securities or cash there's no borrowing involved. The margin requirement is a good faith deposit that you'll be able to cover the future liability. Don't forget the premium received stays in the account. If the short option becomes deep in the money your margin requirements will grow. But if you have to actively monitor this situation you're probably in over your head.
    3) There is a shorting fee, usually about 1% annually, calculated and paid monthly (some full service gents push it over 1%). So one should expect that additional cost when short shares. And yes, the broker keeps this... unless they are actually borrowing the shares from another broker, mutual fund, etc. In that case they are the likely recipients. Shares available for shorting usually come from your broker, check the wording on your margin account. Anything in it can be lent to another investor. The amount of margin generated by the securities held is different depending on the security (cash, high price stocks, debentures, bonds, etc. all have different margin rates). Don't forget you're also responsible for dividends paid on shorted shares.

    Hope this helps...


  11. Tried posting a very long comment, and it seems to have made it to parts unknown. Heres a shortened version:
    1) Tighter spreads are quoted on option combinations.
    2) NEVER use market orders on Montreal. Naturals (bid/ask) are large enough to drive a truck through. Set your price, you'll get filled more often than not.
    3) Beware of higher commissions for option assignment (TD > $40!)
    4) Interest expense on cash borrowed, not margin. Cash received from option premium plus the rest of your account should cover the margin requirement for the put. If you have to watch your margin that tightly, you're in over your head.
    5) Shorted stock is borrowed from someone, and you pay 1% or so per year (calc'd and paid monthly). Expect this expense on shorted shares, and don't forget the dividends too, if any are paid while you are short. Where do these shares get borrowed from... usually other investors at your brokerage, ones just like you, check your margin agreement. Anything in a margin account can be lent out to other investors. Don't want something lent out, move it to your cash account.



  12. Anonymous: Thanks for the detailed and useful information. This is just the type of thing that is missing from the many option primers available online. Discussion of friction won't matter much to someone who wants to get into options to do some gambling, but for a serious investor looking to use options to manage risk, friction is an important topic.

  13. Anonymous: I put your shortened version up along with the original long version. Sadly, I get many spam comments and have to moderate them. Some bloggers choose to post all comments immediately (automatically) and then remove the spam after the fact. I've chosen to moderate comments, which means that they don't appear until I post them. All of this is the price we pay for spam.