Improving Your Options Trade Executions
I was talking to the sales manager at the car dealership this past weekend, and he proudly attested to his company’s “relentless pursuit of perfection.” The very next thing he asked was what I do for a living. As I was briefly explaining puts and calls, I began to realize that I, too, am constantly engaged in my own “relentless pursuit” with regards to my trading. I recognize, of course, that as a trader, one can never hope to be perfect. However, successful traders are relentless in their pursuit of improving their trading processes, increasing operational efficiency, and of course, boosting their win rate. One surefire way to do this is to improve the fill quality of your options trade executions.
Bid/Ask Spreads
The bid/ask pricing on an equity, index or ETF option can vary from a couple cents to a couple dollars these days. The disseminated bid/ask spreads are significantly narrower than in the past due to multiple listing of options on the various exchanges, the prominence of electronic algorithmic trading, and the prevalence of market makers competing with one another for that coveted order flow.
It’s important to remember that you don’t always have to pay the offer or sell the bid when you trade options. Especially when the spread between the bid/ask is wide, you can quite often successfully “work” a limit order that is much closer to the option’s true value.
Options Fair Value
My boss used to ask me, “what’s the market in that spread?” When I told him, he often barked “that market is so wide you could drive a truck through it! Go work that order and get close to fair value!” What is an option’s fair value? Well, there are theoretical values based upon implied volatility and the other greeks that are readily available on many trading platforms these days. A quick and simple rule of thumb to use is to take the mid-price between the bid & ask as the “fair value” at that moment in time for the option.
Options Market Makers
The primary obligation for market makers is to provide a liquid market and fill customer order flow. The key to remember is that one of the main profit generators for delta-neutral-minded market makers is the bid/ask spread. It’s because they hedge the deltas that they buy/sell when they take the other side of an order. For every option buyer, there is a seller, and vice-versa. Invariably, a market making firm is on the other side of your transaction. The wider a bid/ask spread is, the more the theoretical (and often actual) profit margin that a market maker gains (and you lose). Therefore, it’s in your best interest to trade in options in products with the tightest spreads as much as possible.
In the last century when I started trading on the floor, the minimum increment on options was generally 1/8 on options valued over $3.00 (1/16 below $3.00). Yes kids, those are real fractions! That equated to $12.50 or $6.25 on every single option back then! Today you see 0.02 ($2.00) bid/ask spread pricing on the SPY for example, which is a much better deal for retail investors. Despite the big reduction, today’s numbers still start to add up quickly. When you are dealing with “multi-legged” trades (those with more than one option involved) such as debit spreads, calendar spreads, credit spreads, butterflies and condors, the effect of the bid/ask spread is multiplied. You are dealing with 2x the bid/ask spread on 2 legged trades, for example. So, it is imperative that you focus on fair value and then “work” your spread orders to not give up too much edge to those incorrigible market makers!
Options Execution Concept
One method I’ve used for years is to “walk” up my limit order. This walking limit execution strategy will work for single options or spreads, even though the exchanges handle them differently (more about this below). Here is the basic concept...you enter an options day or GTC limit order, you choose a price somewhere between the bid and the ask. I usually start at the midpoint but that’s entirely up to you. If you don’t get filled after a minute or so, navigate over to the working orders tab on your trading platform. When you find your open order, select it and then manually adjust the limit price up a penny and hit <send>. The software should automatically cancel your first order and replace it with a new order with the adjusted price. Let that order rest for some amount of time and then walk it up another penny or two, until you get filled.
Options Broker Execution Platforms
It’s important to mention that you should make sure to check with your broker for platform-specific instructions, because they all work a little differently. For example, some require the trader to manually re-enter a new price and then hit <send> when walking up an unfilled order. Others make it easier for their customers (and more potentially dangerous) by allowing you to adjust the price of your working order by simply clicking on a + or - box found (usually located right next to the working order price).
Further, it’s important to understand the various order types offered through your executing broker’s platform. The quickest way to become adept with these features is to practice using them first in a demo environment but while using live market data. If this feature is not available, spend time practicing after the closing bell has rung! Trust me, I’ve learned the hard way what can happen when testing execution software in a live market data environment. Important caveat, too, is to remember to cancel those practice GTC orders before you finish up for the day!
Don’t be afraid to reach out to your broker to inquire about any tools they offer that can assist you to work your orders with the goal of getting executions closer to the mid-price (fair value). Your broker may offer customizable and even pre-canned algorithms (scripts) that are easy to set up and adjust. That "walking limit" order type that I mentioned above can be automated by using these trading scripts. Instead of requiring you to manually adjust the price $.01, then you must wait 60 seconds, then adjust the price $.02, then wait 90 seconds, etc, all of those commands can be built into the logic using basic scripting language. All you have to do is turn on your script for a particular order and move on to your next more pressing tasks.
And the walking limit is but one example of a plethora of other more sophisticated order types that are out there in the trading world. Get digging and find which other order types you can utilize to help improve the quality of your fills when trading options. I hope you found this article insightful. Every penny you save on your executions is a dollar in your pocket. Over time, your efforts to improve the quality of your options trade executions will be impressively impactful on your bottom line.