YOU’VE GOT THE DATA
In addition to being big and popular, index
options can have a downside: wide bid/ask
spreads. For example, take a look at the NDX
options on the Option Chain of the Trade
page on the thinkorswim® platform from
TD Ameritrade (your base camp for trading
options). By default, the Option Chain always shows the option’s bid and ask prices.
The bid is the price at which the market
maker is ready to buy, and the ask is the price
at which the market maker is ready to sell.
But check out the 6700 calls in Figure 1. The
bid is $235.60, and the ask is $240.60. That’s
$5 wide, meaning that if you sold that 6700
call on the bid, and bought it on the ask, you’d
lose $500. Not so good.
So, why are bid/ask prices of these options
relatively wide? Two reasons. First, the volatility of the NASDAQ futures. NDX-option
market makers hedge their options with /NQ
futures, and the options’ bid and ask prices
are “wrapped around” a fair theoretical
value based on the /NQ price. Because the
price of the /NQ futures can change quickly,
a market maker who buys on the bid price
or sells on the ask price may miss trading
the /NQ future at a price that determined an
option’s theoretical value. The market maker
factors this possibility into the bid/ask, giving herself more “room” (buy on a lower bid,
sell on a higher ask) in case she doesn’t get
her futures executed at her target price.
Second, the NASDAQ options are big in
dollar terms because the price of the NDX
index itself is a big number. The average of
the bid/ask price of that 6700 call is $238.10.
With a $100 contract multiplier, that option
is worth $23,810. Compared to that number,
the $500 in between the bid/ask is about 2%,
which is about the same as some of the most
liquid equity or ETF options. So, yes—the
bid/ask spread of the NDX options is wide in
dollar terms, but not necessarily very wide in
CAREFUL, THERE’S SLIPPAGE
When you’re trading anything, you want to
keep your slippage low. Slippage is the difference between your execution price and
an option’s fair value. Let’s say the fair value
of that 6700 call is $238.10 (the average of
the bid/ask spread, or “mark,” is an estimate
of fair value). If you sold that call at $235.35,
you’d pay $275 in slippage. The savvy index
trader tries to reduce that slippage by using
limit orders, price discovery, and almost
never using market orders.
Avoiding a market order is pretty clear,
because a market order isn’t held to time or
price. A market order can get filled at any
price. And a market maker seeing a market
order come in can take full advantage. The
answer is to consider using limit orders
when trading index options with wide bid/
ask spreads. Just remember there is no
guarantee your limit order will be filled,
especially in fast-moving markets. But what
limit price? This is where price discovery
WHAT’S IN A PRICE?
If bid and ask prices are where the market
maker wants to trade, but those prices have
too much slippage for you, price discovery
is where you find the price at which you and
the market maker can execute a trade. This
minimizes your slippage, while still giving
the market maker an incentive to trade.
To start, look at the bid/ask size of the option, also on the Option Chain. For that 6700
call, it’s 52 x 57, meaning there are traders
willing to buy 52 calls for $235.60 and sell
57 calls at $240.60. If you want to sell five of
those calls, for example, you can begin your
price discovery by routing a limit order to sell
one at just above fair value, maybe $238.15. If
you sell it there, great. You just traded close
to fair value and may want to offer the other
four at $238.10 as well, because that seems to
be the call price at which traders are willing
But say you offer that call at $238.10 and
it’s not filled. The other 57 that were offered
at $240.60 now join you on the offer, such
that the bid is now $235.60 for 52, and the ask
is now $238.10 for 58. Perhaps you’re getting closer to those traders’ preferred price.
On the other hand, if no trader joins you at
$238.10, you’re still on your own. In either
case, you could consider canceling the first
order, and maybe sending a new limit order
to sell one at $238. Now: do you get filled at
that price? Are other traders joining?
THIS IS THE PRICE DISCOVERY PROCESS.
You take your order to sell one call down
$0.05, or $0.10, at a time, until you’re filled—
hopefully above the bid price. At that point,
you’ve discovered what the trading price
is, and you can route your other four at that
price with a good chance of getting filled.
This approach to price discovery give you
a chance to reduce slippage when you trade
high-priced options. Plus, you’re learning
how traders think, and building incomparable trading muscle in one of the biggest
arenas there is. And that can make you a
savvy index trader.
FIGURE 1: Wide bid/ask spreads. Index options are big, powerful, and have wide spreads. Look at the bid and
ask prices on the Option Chain from the Trade page of your thinkorswim platform.
Source: thinkorswim® from TD Ameritrade. For illustrative purposes only.
Thomas Preston is not a representative of
TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the
author and may not be reflective of those held by
TD Ameritrade, Inc. For more on the risks of trading
and trading options, see page 37, #1– 2.