TRADING FLOOR SECRETS: Stop Throwing Money Away on Bid-Ask
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May 30, 2007
I recently answered a question on my discussion boards that I feel is an important lesson for all looking to trade. I do not want to see anyone giving away money, but I feel that this is exactly what may be going on because of a misunderstanding or the proper way to look at the bid-ask spread.
I know that many people do not read my boards for a variety of reasons so I thought I would post this lesson on the article''s site. The reader''s question was:
“Can Condors be profitable? Eight percent for the bid/ask and commissions of around about 15 % (spread) that is a total cost of around 25 % to enter the trade?”
My response was:
“The slippage of a many leg trade is a concern that I have addressed previously and feel the need to state again. I know I will touch on it during my filibuster at Oasis this year when discussing BWBs.”
All options are priced off of a theoretical value based on one of many different option pricing models where some assumptions are made about future volatility.
Assumption 1
When looking at an option on XYZ which trades for $3 bid - $3.20 ask one must realize that there is only one price the traders are looking at and that is the theoretical value, call it $3.10 in this example. They will then move the bid-ask spread around the theoretical price to create an edge for themselves.
Assumption 2
Just like each option has a theoretical value each spread also has a theoretical value. The theoretical value of the spread is NOT $0.20 bid-$1.20 ask – it is one price and the traders create a bid-ask spread around that theoretical value.
Assumption 3
A naked option usually has more risk associated with it than a spread. Because a change in the underlying moves a naked option''s price around with greater speed than a spreads price, traders will make sure the bid-ask spread of a naked option is wider than that of a spread. The reason: They have to hedge every trade and anything can happen between the time they consummate the trade and they turn around to hedge with stock or futures.
Assumption 4
With the naked option we saw a bid ask spread of $0.20, whereas with a spread the reduced leg risk requires less of an edge for the trader. As a result, the same underlying may have a butterfly spread which only has a bid-ask spread of $0.10. Adding all the slippage of 4 pieces of a butterfly together is not only not how it works but subjects you to way too much generosity towards the floor traders.
Assumption 5
As a practical example... I spent many years in the SPX pit. It is a beast of a pit when you consider it is a $1,500 stock. The bid-ask spread of an ATM option easily can exceed $1. Yet, if you have your broker ask for a quote on an ATM butterfly coming right from the pit (instead of just playing with the bid-ask spreads on the screen) you will usually hear something like, “$0.40 bid-$0.45ask”. Yes, they will reduce butterfly spreads sometimes down to a $0.05 bid-ask spread only needing a $0.02 ˝ bid-ask edge over theoretical. Why? Because there is no delta, gamma, theta or vega associated with a butterfly spread as a unit.
Assumption 6
Most of you are giving up too much bid-ask edge to the traders and though intuitive the method you used to calculate a spreads price, it is in fact the opposite of how things work practically. It is reasons like this that learning from people who have done this before for a living is the best way to learn. It costs a lot less over the long run to learn one simple trick like this and pay for a seminar than to spend years giving up large bid-ask spreads before realizing you have given away a fortune.
Assumption 7
Best way to avoid paying too much? Like I was showing a month or two ago with my BWB examples, I simply determine what the mid-point of the entire spread is and go from there. On a BWB which had perhaps $1.50 total bid-ask spread going off the naturals I would do things different. I would find the mid-point of the spread which is usually pretty close to where the theoretical value of the spread trades.
From there I would give up $0.10 to buy the spread and $0.10 to sell the spread. If, for example, the mid-point of a certain BWB was 0.30, I would pay $0.40 to buy it and sell it at $0.20. This would reduce the bid-ask spread down to about $0.20.
I hope this helps. This is my gift to those who are dedicated to doing this for a living.
Scott Kramer
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
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