Each week I’ll address a FAQ or common misconception that I see posted by new traders dozens of times a day. Everyone is also welcome to find these answers in our FAQ wiki.
Previous posts in this series:
Your break-even isn’t as important as you think it is
Exercise and Expiration are not what you think they are
- If you don’t remember anything else from this post, at least remember this: The narrower the bid/ask spread, the better deal you are going to get on your trade. Avoid wide bid/ask spreads whenever possible.
- Every contract is up for auction, with active buyers and sellers, represented by the bid/ask spread, respectively.
- Every contract also has a daily volume and open interest.
- The price of a contract is not defined by some kind of central authority or by a pricing model, it is discovered by active trading.
- When your broker calculates a gain/loss for today or since open, they use the “mark”, which is the mid-point or average of the bid/ask spread. It is an estimate. It is not what you will necessarily get if you closed a trade in that moment.
- The “market” is the bid when you are a seller and the ask when you are a buyer.
- Consequently, you must be an active participant in the auction in order to get the best possible price. You can’t just fire and forget an order and hope for the best.
- There are two types of orders for opening a trade and four types of orders for closing a trade.
- For opening, there are market orders and limit orders. NEVER USE A MARKET ORDER, EVER.
- For closing, there are the same market and limit orders as for opening, as well as stop-loss orders and stop-limit orders, to put a floor under your losses on closing a trade. NEVER USE A STOP-LOSS ORDER, EVER.
- Liquidity and the width of the bid/ask spread are highly correlated.
- Liquidity is a critically important factor in determining how cost-effective your trades are. Consequently, liquidity should be a priority when selecting option chains and contracts.
Options are auctioned — it’s EBay, not Amazon
Many new traders seem to believe that the price of a contract is set by some central authority and that looking at the quotes in an option chain is some kind of static price list, like a menu at a restaurant. Nothing could be further from the truth. All option contracts, as well as stocks and ETPs, for that matter, are traded in an auction. There are active buyers and active sellers.
This means that the current price for a contract is fluid, ebbing and flowing as the number and urgency of the buyers and sellers fluctuates. The current state of the auction is defined by the bid (the highest price buyers are offering to pay) and the ask (the lowest price the sellers are willing to accept). Since there may be more than one contract up for auction at any given time, the bid and the ask each have a size, represented by xNNN. The NNN is the minimum number of contracts a buyer is willing to buy or a seller is willing to sell. Example: $1.23×100/$1.38×23 — this means 100 contracts sought for $1.23 and 23 contracts on offer for $1.38.
The bid and ask only represent the “top” of the order book. Prices that are higher than the ask or lower than the bid are recorded in the order book. The details of the order book and Level 2 real-time quotes are beyond the scope of this article, but if you wish to learn more, you can read an explainer here.
Contracts at a specific strike and expiration have a volume number, which represents the number of completed trades on that contract for that day up to that point in time. There is also an open interest number that represents the number of contracts in open positions in the hands of traders or market makers. It is similar to the float of outstanding shares for a stock. More about volume and open interest here.
It is worth noting that for the most part, the active bids and asks you see in the auction are market makers. That is why a contract with 0 volume still has an active auction, because the job of market makers is to, well, make a market. That means to act as a buyer if you are selling and a seller if you are buying.
Given that there is an active auction for every contract, how is the current value of a contract determined? The process of determining the current value is called price discovery. Again, the details are beyond the scope of this post, but if you wish to learn more about price discovery, there is an explainer here. For this post, the point I’m making about price discovery is that the current value of a contract is any number between the bid and the ask at that moment in time. Until a trade actually happens, the exact value is unknown, but not unbounded. Therefore, you cannot say with authority that the value of your open position is $X. At best, that is an estimate.
Does that mean the gain/loss of my position is defined by the last trade?
No, not for options.
Your gain or loss has to be based on the current price, but if no trades have happened (volume is 0), or the last trade was an hour ago and the auction has moved far from the last trade, how does your broker know how to calculate the current gain/loss?
Your broker estimates the current value of the position by using the mark. For options, the mark is the average of the bid/ask spread. It is sometimes also referred as the the mid (middle) of the bid/ask. Example: If the bid/ask is $1.00/$3.00, the mark is $2.00 and that is used as an estimate of the current value of the position. Even if the last trade was $1.50.
This is the reason almost every long option trade is opened for a loss. You almost never get the mark as your actual trade price when your order is filled, so the distance from the amount you actually paid to the mark is often treated as a loss. For example, using the $1/$3 spread again, if you end up filling your order at $2.10, your broker will show a current loss of -$0.10 on the trade, because you bought at $0.10 over the mark. If you bought or sold at the market, which is the bid for a seller or the ask for a buyer, you will show half the width of the bid/ask spread as a loss on open. More about mark and market in the section about order types and getting cost-effective vs. fast fills.
My buy-to-open at the mark never fills! That means my broker is stealing from me, right?
Wrong. Or at least, very unlikely. That has more to do with not accounting for the options market being an active auction. You can’t just set an order and hope for the best. You need to actively bid if you are a buyer, negotiating a price that a seller will accept. Sometimes you need to increase your offer to get a fill, sometimes you need to wait patiently for the market to move towards you.
A maxim that I found useful for active trading is: Getting a fill on an order is a contest between your greed and your impatience.
What that means is that, most of the time, you can either get the price you want or a fast fill, you can’t have both. The more money you want as a seller (or the less as a buyer), the longer you may have to wait.
So once you decide on which way you want to go, best price or fastest fill, you can then participate in the auction accordingly. For the rest of this description I will assume you want a fast fill and are willing to compromise on price. Because the opposite it just a waiting game.
To get a fill relatively quickly, what I do is start at the most favorable price for me and then negotiate towards the market. For example, as a buyer, I open bidding at one increment away from the bid. If the bid/ask was $2/$3 and the minimum increment of price is $0.05, I’ll start my order with a limit of $2.05 (more about limit orders below). I wait 10 seconds for that to fill. If it doesn’t fill, I modify the order (cancel the order, replace with a new order) to $2.10 and wait 10 seconds again. I keep doing that until I get a fill. Sometimes that means I end up paying a price that is above the mark. Sometimes it means I pay a price that is close to the market. That’s the cost of getting a fast fill.
Why not use a market order?
Market orders give you minimum time but at maximum cost.
There are two types of orders for opening a trade and four types of orders for closing a trade.
For opening, there are market orders and limit orders. A market order means fill my order at any price. A limit order means fill my order at a price that is at or better than my specified limit, whichever is best. From the definition alone it should be clear why you should never use a market order. You are putting yourself at the mercy of the auction and the order book and could end up paying much more, or getting much less, than you could have gotten with a little more patience. In fact, some traders actively seek to exploit naive use of market orders by placing “traps” in the order book, which are ridiculous prices that no one would pay or accept, but that could be snagged by a market order if the top of the order book is cleared out. Or the trap is set to snag a large dollar value order that intends to “sweep the book” and clears out all the normal orders in the book and runs into one of these traps.
Long story short, don’t use market orders to open, ever. If you want a fast fill, use the method described earlier which, in practice, will get you a fill within 5 minutes, and often in less than 30 seconds. It you absolutely must have the fastest fill possible, set a limit order at the market price or one increment beyond.
For closing, there are the same market and limit types as for opening. There are also stop-loss and stop-limit orders to make sure you don’t lose more than you want to lose. The stop-loss turns into a market order to close when the designated stop price is met. A stop-limit turns into a limit order (at the specified limit price) when the designated stop price is met.
Never use market or stop-loss orders to close, ever. If you want a floor on your loss for a sell-to-close order that will fill as quickly as possible, set a stop at the worst price you will accept and the limit at $0. A limit is always filled at the limit or better, whichever is better, so if you want to fill at the stop price or as close to the stop as possible, your best chance is with a limit at $0. Or work you way up from $0 to a more reasonable price, if you think a sharp drop is unlikely. For example, if you bought a call for $5 and you want to stop at $4, you can set the limit for a stop-limit at $2. The lower you set the limit, the less risk there is that a sharp drop will leave your order unfilled. But that doesn’t mean you will only get $2. You’ll get the best price that is above $2.
What about liquidity?
Liquidity is a little hard to define for all cases, since it is somewhat context dependent. The relevant Investopedia definition is “liquidity describes the degree to which an asset can be quickly bought or sold in the market at a price reflecting its … value.” Put another way, the better liquidity is, the better deal you’ll get from a market maker. The worse liquidity is, the more you will be ripped off by trading with a market maker.
The width of the bid/ask spread is highly correlated to the liquidity of a contract, to the point where we can say that the bid/ask spread represents the liquidity of the contract. The volume and open interest are also factors in liquidity, but in practice while trading, where liquidity hits you the most is in the bid/ask spread. As a gross oversimplification, the width of the bid/ask spread is the mark-up a market maker adds to the wholesale value of a contract. The wider the spread, the more of a premium you will pay as a buyer in order to own the contract, or the more of a discount you will have to offer as a seller to get a fill.
There is also an analogy to competition. Consider something highly perishable that can’t be easily shipped from Amazon, like live aquarium goldfish. If there are five pet stores in town, you have a pretty good chance of getting a good price on a pair of goldfish that you want to buy, because each pet store knows you can go to the one down the street to get a better price. The competition helps keep prices down as a buyer, because some store can always undercut another store on price, until price reaches an equilibrium that’s close to it’s wholesale value plus a reasonable mark-up. But if there is only one pet store in town and the next store is more than a 3 hour drive away, your local store can gouge you on price for a pair of goldfish, because where else are you going to go for a better price?
Options liquidity works similarly. If volume is low or zero, where are you going to go for a better price? Bid/ask spread can be as wide as market makers want it to be, because there is no one else to undercut those prices. Whereas if volume is high, there is more incentive to undercut competitors and close a trade, because a little money is better than no money if no trades happen, from the market maker’s perspective.
The upshot of all this is that when you are looking for options to trade, select underlyings that have highly liquid option chains. Given an expiration or strike with low volume and wide bid/ask spreads versus a different expiration or strike with high volume and narrow bid/ask spreads, choose the one with high volume and narrow bid/asks.