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Chapter 2. Option Basics > Trading Costs in the Option Analysis

Trading Costs in the Option Analysis

Risk analysis often involves small margins, and it is easy to overlook all of the elements that go into that margin of profit. Trading costs are especially troublesome when you deal in single-option trades. The per-contract cost is relatively high. We prefer using single-option examples throughout this book to keep those examples clear, but in practice, the trading costs affect your likely profits on both sides of the transaction. Trading fees vary widely, so you must shop around. You may discover that the brokerage you have been using to execute stock trades is not necessarily the best-priced for option trades.

The problem with multiple-contract trades is the increased risk exposure. It does not make sense to involve 10 options just so that the per-contract trading price is lower. Is it practical to increase risk 10 times by using that many options? It might be in some situations, but reducing trading costs should not be the primary criterion for employing multiple option contracts. The determining factor is potential return and risk level compared to the ultimate conservative goals in your portfolio. For example, let's say you own 1,000 shares of stock. You might decide to write covered calls on as much as 300 shares, but you don't want to write calls on all 1,000 shares; in the event of exercise, you'd profit from option premium income, but you may also like to keep the remaining 700 shares. In this case, it would not make sense to write 10 calls just because you own 1,000 shares. Yes, trading costs would be lower, but it may also violate your risk standards. In this case, you would not be willing to have all of your shares called away, so you decide to write calls on 30 percent of your holdings. The trading costs are only one factor to consider; your desire to retain the other 70 percent of your portfolio is more important. If all 10 calls were exercised and 1,000 shares were called away, you would regret the decision even though it worked out profitably.


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