Option Trick Market Makers Can’t Fight

06/07/2012 7:00 am EST

Focus: OPTIONS

Option traders can swing a regulation called the "show or fill rule" in their favor to produce small but consistent returns on their trades, explains Alan Ellman of The Blue Collar Investor.

An integral aspect of our options trade executions is to sell at the “bid” and buy at the “ask.” Many times we can “negotiate” the bid to a higher price or the ask to a lower price. Would you like to earn $50 in 50 seconds? Why not learn how to play the bid/ask spread?

Blue Collar Investors throughout the world are always looking for ways to generate additional profits into our portfolios. This includes the use of some of the more esoteric maneuvers that may produce small returns of $40, $50, or more.

One of the main philosophical approaches to Blue Collar Investing is that by generating small but consistent, low-risk returns, and then compounding those profits, we can become financially independent.

In my previous books and DVDs, the following phrase appears on numerous occasions:
Sell at the “bid”, the lower price; buy at the “ask”, the higher price. This references the price lists found in the options chains.

Before we discuss some common sense applications to maximizing profits by playing the bid/ask spread, let’s review some definitions (stay awake now, this can make you some cash!).

Definitions as they apply to options:

Bid: An offer made by an investor, a dealer, or a trader to buy an option. It will usually stipulate the price at which the buyer is willing to purchase the option and the quantity to be purchased. As covered call writers, we sell at the “bid.”

Ask: The price a seller is willing to accept for an option, also called the offer price. The “ask” will always be higher than the bid.

Bid/Ask Spread: The difference in price between the highest price that a buyer is willing to pay for the option and the lowest price a seller is willing to sell it. If the bid is $2.80 and the ask is $3.00, then the bid/ask spread is $ 0.20.

Theoretical Value: The hypothetical value of an option as calculated by a mathematical model such as the Black-Scholes Option Pricing Model.

Black-Scholes Option Pricing Model: A model used to calculate the value of an option by factoring in stock price, strike price and expiration date, risk-free return, and the standard deviation of the stock’s return.

How the Bid/Ask Spread Is Set
There may be several bid prices and several ask prices at any point in time. However, only the highest bid and lowest ask are used to calculate the spread. These are the figures you see when accessing the options chains. 

Utilizing an estimate of the volatility of the underlying stock, a theoretical option value is calculated using an option pricing model, such as the Black-Scholes model.

A market maker will then set the bid below this theoretical value and the ask above this theoretical price. This is the spread and is determined mainly by liquidity.

For example, the highly liquid PowerShares QQQ Trust (QQQ) has bid/ask spreads as low as $0.01. This is one of the reasons I require all stocks owned in our portfolios and on our watch list trade at least 250,000 shares per day and options to have an open interest of 100 contracts and/or a bid-ask spread of $0.30 or less.

Market makers derive their profit from bid/ask spreads. The greater the spread, the more money they make. Playing the spread will decrease their profits and increase ours.

Market Order vs. Limit Order
If you use a market order when executing a trade, you will sell at the published bid price and buy at the published ask price (this is called “lifting” the offer or “hitting” the bid). This may be okay for the purchase and sale of stocks where the spread is tight (small), but for options, which have a wider bid/ask spread, a limit order is more appropriate and beneficial.

The Show or Fill Rule
This is also called the limit order display rule, or technically, the Exchange Act Rule 11Ac1-4. This regulation requires the market makers to show or publish any order that improves the current bid or ask prices unless it is filled. Any order between the current bid/ask spread will improve the market.

Practical Application
Most exchanges have a policy in place that requires market makers to fill at least ten contracts at the quoted price. For many equities and ETFs, the number of contracts required is a lot more and varies from security to security. These players want to buy securities at the lowest price (bid) and sell at the highest price (ask or offer).

Now it’s time for Blue Collar Investors all over the world to become annoying and take out our slingshots in much the same way that David approached Goliath. As long as the bid/ask spread isn’t too tight or close together, we place our order between the two quoted prices. If the market maker (MM) does not fill the order, he will be required to publish it and then be obligated to fill at least ten contracts (perhaps more) at that price. 

Since most of us are selling small numbers of contracts, let’s say up to five per stock, it is in the best interest of our friends on the other side to just fill our orders and settle for a lower amount on five contracts rather than be obligated for twice that amount and for many more traders. We got them right between the eyes…I mean between the bid/ask spread.

NEXT: Trade Example

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Trade Example
In this hypothetical example, the bid is $2.50 and the ask is $3.00. That’s a spread we can work with. As covered call writers, we sell at the bid, or in this case, $2.50 per share, or $250 per contract. That’s the price at which the MM wants to buy our options.

Instead, our offerwill be $2.65. That betters the current published offer of $3.00. Therefore, our friend on the other side has a dilemma: Do I fill these five contracts at $2.65 or publish the new, improved offer and be responsible to fill ten or more as required by the Show or Fill Rule? In most cases, we will get our $0.15 and the MM will get rid of us. This little maneuver will pay for our commissions and buy us lunch at Wendy’s.

So $75 becomes hundreds, which becomes thousands, which becomes tens of thousands, and so on. And the market makers? They’re gazillionaires anyway…they’ll be alright.

The one trick to this is not checking the “All or None” box in your option execution platform screen. Mine looks like this below, but yours may be slightly different:

chart
Click to Enlarge

For most of us, checking this box is redundant and not necessary because the MM is required to fill at least 10 contracts. If this box is checked, the MM is no longer required to publish our offer and we will lose our leverage when playing the bid/ask spread.

A market order should always get filled as you are buying a said number of shares “at market” so you will hit offers until you have a fill. Limit orders will only fill at your specified limit price or better. If you don’t want partial fills and you are trading a large number of contracts, you can use the All or None order. They will fill the whole order or nothing. However, this will be counterproductive when playing the bid/ask spread.

Conclusion
To take advantage of the show or fill rule, we must:

  1. Improve the market (bid/ask spread)
  2. Sell ten contracts or less
  3. Not check the All or None box on the trade execution form

Blue Collar Investors have certain tools available that will level the playing field with the MMs. Taking advantage of the Show or Fill Rule is an important one, especially when selling a small number of contracts.

Although each successful trade will generate a small amount of cash, over time this will add up to significant dollars that will help to secure our financial future. Unlike David, though, we are not looking to injure our adversaries…just annoy them.

By Alan Ellman of The Blue Collar Investor

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