Have you ever placed an order where you received an immediate fill and then thought you may have been able to get a better price? Maybe you could have bid ten cents less and still received a fill. How about sending an order that you think should get filled, but after waiting twenty minutes or so, you start thinking to yourself: “These floor guys are playing games with me.” Well, I’m going to explain how you can read the bid ask spread to place efficient orders. This may also give you a little more comfort in placing orders. Efficient and effective use of limits is a must if you plan to successfully trade. After all, if we can save on every trade, these savings will add up to a sizable reward by years end.
Three Market Types
Start by classifying the bid ask spread into one of three categories. This classification helps us to place better orders.
1. The Screen Driven Market: This is the most common quote. In the absence of any customer orders, what is displayed is the specialist’s “Driven Market.” The Driven Market is a bid and ask that is supplied by a machine around a fair (theoretical) value. The exchange has rules as to how wide the specialist is allowed to set the bid ask spread on an option. What determines this width are the price level of the option, the time until expiration, and current market conditions. The widths are generally fixed amounts. For example: All options over fifteen dollars have a bid ask spread of one dollar eighty cents; options between fifteen and five are a dollar forty wide; and options under five have an eighty cent wide spread. This is the widest quote that we can expect to see when looking at the bid ask spread.
Figure 1: http://www.optionstradingandmentoring.com/TradingArticles.aspx?ArticleId=02
2. The One Sided Market: This spread is a customer’s order being represented on one side of the bid ask spread. The customer’s order is better than the crowd and has created a lopsided spread. The other side of the market is the screen driven market listed above. We can spot this market easily once the market moves and all the bid and ask prices shift. One price will not move with the rest, this is a sure sign that this is a customer order.
For example, in Figure 2, we might see all the bids and offers increase by a dime except for the 1450 call offer. If so, this is a sure sign that the forty-one offer is another customer order. We then look to the ask size to see if it also looks like a customer order. Sure enough in this example, there is only one contract offered at 41.00. All the other bid and offer sizes are showing ten contracts. The ten contracts are representing the specialist size on all markets and confirm these spreads are a screen driven market.
Figure 2: http://www.optionstradingandmentoring.com/TradingArticles.aspx?ArticleId=02
3. The Two Sided Market: This market has customer orders on both sides of the market or there is a customer order on one side and the pit's best bid or offer is being displayed on the other side. This can be the best market quote, if you want to trade opposite the customer order you will be able to trade this option for better than fair value. This market is often only a dime or two wide. In Figure 3 we have a two sided tight market on the 1415 calls. The 1415 calls have a thirty cent wide market verse the 1420 calls with a one dollar eighty cent wide market. (Quite a difference!)
Pricing Orders
Now that we have classified the bid ask spread into three categories, we will determine the fair value of an option for each category to place an appropriate order. You may have to give some amount off of fair value to the market maker to get your order filled. One generally offers below fair value by ten to twenty cents and bid above fair value by ten to twenty cents. The examples below will assume bidding over and offering under the fair value by ten to twenty cents will result in a fill.
Figure 3: http://www.optionstradingandmentoring.com/TradingArticles.aspx?ArticleId=02
There are other tactics of “going for value”, i.e. placing a limit order at fair value and waiting for someone who might be willing to trade for value too. In this approach, you would then “cave-in” a dime or nickel at a time until your order gets filled. Below, we will attempt for a faster fill by giving away fifteen to twenty cents to the market maker off the fair price right out of the gate.
Now that we know how to classify the bid ask spread into one of the three types, we can discuss finding fair value and place our order for each type of market.
1.The Driven Market - These quotes are created with equal distances above and below the specialist’s fair value. The specialist or market maker will trade around the fair value, selling options over fair value and buying under fair value. Since these quotes are disseminated by a computer and equally spaced around the fair value, we can assume the fair value as the half way or middle point of the quote. If you place orders twenty cents off fair value in the market maker’s favor from the middle point, you should get filled. This “edge” or twenty cents to the market maker will vary across markets. A nickel might work in an equity market and twenty cents in an index. In fast market conditions you may have to give away forty cents for a fill. It will vary depending on conditions and underlying markets.
2.The One Sided Market - This market is one we don’t want to just “middle”. If we look at the 1450 call market in Figure 2, and decided to middle the market to determine a price we might trade at, we will have made a mistake. The middle of the bid and ask is 39.70. After seeing the prices of all the other options change due to underlying movement, and we noticed that the 41.00 offer on the 1450 calls didn’t move, we determine this is a customer’s order. Knowing the markets are four dollars wide, we can add two dollars to the 1450 call bid to get fair value. This will place fair value for the call at 40.40, and this is the value we should use to determine where to place our order. If we just calculated the mid-point and sent an order to sell the 1450 call at 39.50 (twenty cents lower than the mid-price), we would get a fill. But this fill wouldn’t be a good one, as we could have sent a price of 40.20 and also received a fill. By identifying the correct market, we could have saved seventy dollars per one lot traded.
Likewise, if we sent an order to buy the 1450 call at 39.90, our order would not get filled and just sit there. Having determined that 40.40 is fair value, this bid of 39.90 is not going to get filled by a market maker as he would pay that price too.
3.The Two Sided Tight Market – For this market, we will use theoretical values. We determined in Figure 3 above that the 1415 call had a two sided tight market. How can we determine the fair value? We will look to a strike right next to this strike for some help. Looking at the 1420 calls, we know this is a driven market so we can just middle the 1420 bid and ask. The fair market value of the 1420 calls is 37.70. Now we compare this 37.70 fair market price to the theoretical price at 37.63. The theoretical price is .07 under the current fair value. We will assume that this same difference exist one strike down at the 1420 strike. Adding the .07 to our 1420 theoretical price we now have a fair market price of 40.08. The current bid is 40.00. I would guess that this is a customer order and he is currently willing to pay .08 cents under current fair market value. This order will not last long. Once the underlying moves and the market markers see this option priced twenty cents over the fair value, they will take it out. If we were looking to sell this option, this would be a great price as it is .07 under current fair value and .01 under theoretical price.
In conclusion, this method does not guarantee you get the best fill all the time. It should improve your chances and your understanding of the bid ask spread. It helps one determine where to place orders that result in a fill close to the best price. It also helps explain why some orders don’t get filled. Please visit my site www.pitsavvy.com
