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Getting Great Entry Prices in Options
06/07/2011 6:00 am EST
Option spread traders can gain an advantage and take less risk by entering spread orders as opposed to "legging in" to their trades.
I recently received an email question about “legging in” to an option spread. Legging in refers to taking a partial position size to test the waters and ensure you’re getting the best entry price.
Here is the question: “I like trading Russell 2000 Small Cap (RUT) spreads but I’m not sure if its better to place a spread order or just leg in. Does a spread order make more sense with a smaller order? I can see trades occurring at the spread price I want, but I fail to get filled.”
It is far more practical to enter a spread order. In the vast majority of cases, it is also less risky. The primary reason for that extra safety is that you cannot get trapped by a sudden market move after buying or selling the first leg of the trade.
Very Actively Traded Options
There are exceptions to my recommendation for entering spread orders, however. If you trade front-month options, especially options that are nearly at the money (CTM, or close to the money), then there is a lot of trading volume and a continuous flow of orders. What that means to you is that there is a much-improved chance to get a good fill...and quickly.
The bid/ask spread for a CTM option is $10 bid/$10.80 ask. When there is a constant order flow, this option will be trading—at least every second, and probably far more often than that—at prices ranging from $10 up through $10.80, and probably every ten cents in between those prices. And this ignores all those trades that occur at penny increments.
If you enter a sell order at $10.50 or even $10.60, there is a very good chance that you will get filled when another customer is trying to buy that option and is willing to pay a price near the ask end of the range. Notice that you do not have to depend on a market maker to get filled. You are going to be trading with customers just like you; people who enter orders.
Once filled, it’s time to enter the order for the other side of your spread. The expectation of getting filled is as before. If it’s a very actively traded option, you have a reasonable chance to get a good price. However, there is the huge risk of a sudden change in the air. If you buy a call, RUT may decline a few points in a heartbeat, and far too soon to get your other order filled. That’s the risk and it is real.
Less Liquid Options
If you prefer to trade out of the money (OTM) spreads, then you must recognize that there is less order flow, less volume, and less chance of making a successful leg. If you trade options (as I do) that are not only reasonably far out of the money, but are not even front-month options, then the chances for a good leg are dismal.
These are low-Delta options, and even if you get a good leg as far as market direction is concerned (buying a call just before the market moves higher, for example), there will still be difficulty getting a fill on the sell part of the spread. Low-Delta options don’t move much, and they move even less when implied volatility shrinks, even if by a minute amount.
NEXT: Problems Getting Filled, Trade Size, and More|pagebreak|
When You Don't Get Filled
To be filled on a spread, your broker’s computer must be able to execute both (or all) legs of the trade simultaneously. When you think that trades are occurring at your price, please understand that they may be off my a few milliseconds, and that’s more than enough to prevent the computer from grabbing both ends of the trade for you.
And when you see trades you think should be yours, consider that when one leg is offered at one exchange and the other leg is offered elsewhere, it is more risky for the broker to go after the legs. You must ask your broker what conditions must apply before their trading algorithm allows your order to get filled.
But more than that, what about all the market orders? They just get filled. There is no opportunity for that market order to find your spread order, or to be found by that spread order. The system has too many participants and a market order hits the highest published bid (or takes the lowest published offer) and it does it immediately. Those trades are never available to your spread order.
I see one advantage and one disadvantage in trading small order size. To get a fill, you must attract a market maker’s interest. Small orders do not accomplish that.
However, when trading with other customers, there is an increased chance to fill the whole order, rather than just part of it, when trading two lots instead of ten.
Legging in adds extra risk, so if you do make the attempt, be absolutely certain that you will not get stubborn about finishing the spread, even when the price is not as good as you prefer. If you are trying to earn an extra ten cents per spread, there has to be a correspondingly small loss from getting a poor fill.
I’ve seen traders lose dollars trying for dimes. It’s not a good practice to take the leg unless you are a very skilled market timer.
By Mark Wolfinger of Options for Rookies
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