Rules of Thumb for Option Pricing

04/02/2015 8:00 am EST

Focus: OPTIONS

Moby Waller

Editor, Wyatt Research

Moby Waller, of BigTrends.com, explains why option bid/ask spreads are narrower than they’ve been in the past and outlines tips for newbie option traders to remember including how to quite often successfully work a limit order that is much closer to the option's true value.

Working the Option Market Maker's Bid/Ask Spread

The bid/ask pricing on an equity, index, or ETF option can vary from a couple cents to a couple dollars these days. In general, bid/ask spreads are narrower than in the past due to multiple exchanges, the prominence of electronic trading, and market makers competing for retail option 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 (or showing wide on the currently displayed quotes), you can quite often successfully work a limit order that is much closer to the option's true value.

What is an option's true value? Well…there is intrinsic value and time premium in an option price—there are theoretical values based upon implied volatility and the other Greeks, which are readily available on many trading platforms these days—but the rule of thumb I often use is to take the mid-price between the bid & ask as the fair price at that moment in time for the option. Be sure to check a couple strikes around the one you are interested in as well, to make sure that one particular option is not out of line in terms of pricing and implied volatility. 

Also, check the at-the-money options at that expiration to see if the options appear normally priced or have a dividend or other event priced into them. The basic formula is (Call Price – Put Price + Strike Price) should be close/equal to the underlying stock price (this is also known as Reversals and Conversions).  Longer-out expirations will have margin interest rates and other factors priced into them as well.

One Source of Market Maker Profit Is Bid/Ask Spread

The primary obligation for Market Makers is to provide a liquid market and fill customer order flow. The key to remember is that the one of the main profit generators for delta-neutral market makers is the bid/ask spread, because they hedge off 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.  The market making firm is on the other side of your transaction.

So the wider a bid/ask spread is, the more the theoretical (and often actual) profit margin that a market maker gains. For example, if an option is bid 2.00, offered 2.50…the MM is paying $200 and selling for $250. In a perfect world, he/she would buy and sell the exact same amount of those options for those exact prices…leaving a net position of 0 at the end of the day and a risk-free arbitrage profit of $50 per contract traded.

In that hypothetical example, the overall profit margin of the bid/ask spread is 25%…also based on the mid-price (aka the estimated fair value) of 2.25, if you pay the straight ask or sell the bid, you're giving up about 11% edge on both sides of the transaction to the market makers.  So as a retail options trader, it's in your best interest to narrow the spreads as much as possible.

In this example, if you paid 2.40 for the option, you're lowering your cash outlay and maximum risk by $10 per contract, or about 4% from the 2.50 price.  You're also reducing the edge over fair value you give up to $15 from $25…down to only 6% profit margin on each side of the trade (much more reasonable in my view).

The good thing is that nowadays with so much competition for option volume (and with $1 strikes, 0.01 price increments, etc), you are much more likely in an example like the above to get filled on a limit order below the ask or above the bid.

In the old days of fraction option pricing when I was a CBOE floor market maker, the minimum increment on options was generally 1/8 on options over $3 (1/16 below that)—equating to $12.5 or $6.25—today, you often see 0.01 ($1) bid/ask pricing on the SPYders for example, a much better deal for retail investors.

NEXT PAGE: What About Competition for Orders?

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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 most 2-legged trades for example.  So it is even more important there to calculate a fair value and then work your order to not give up too much to those taking your trade.

Let's look at a long ago example of this from the ETF Tradr program.  We had nice profits on a Regional Banks ETF with a bearish Put debit spread. This ETF was one of those equities where the quoted prices at the time on the options are often much more wide than the real prices where you can get filled.

In this situation, the five point Put debit spread was priced at 2.80 by 4.00 (our subscribers paid 2.20), this pricing on the quote screens was too wide to fairly trade from the retail investor side.
In this case, you take the bid/ask average of 6.80/2 or 3.30 to garner what is the estimated real value at that moment in time.  So we issued our exit price alert to sell half the position at 3.20…giving up only $10 below what looked to be the fair value (additionally, this position was fairly deep in-the-money at this time, which made it more likely to be filled near the true value).  Again, we always take into account Intrinsic Value (and Time Premium or Extrinsic Value), and also, factors like Implied Volatility and Option Greeks to approximate the fair value of an option or spread at a given moment in time.

We got filled basically instantly at better prices than our limit order and the quoted bid/ask prices narrowed significantly as well for a time.  You may wonder why don't they leave the bid/ask prices narrower all the time?

Well, on a security like this, it sometimes looks like there may be an unspoken agreement among those who make markets in the options to leave the bid/ask prices wider than they really are (to take advantage of market orders and novice traders).  I'm not saying this is a nefarious conspiracy, it can just be that the primary market making firm has a default bid/ask pricing in the computer with very wide bid/ask spreads.  The real market is often narrower than you see on the screens.

Generally, low volume on either the underlying or its options can contribute to these wider posted bid/ask spreads. They also don't want to be caught off guard by a slew of electronic orders that may precede a big move in the stock, so they give themselves more slippage by posting wider bid/ask spreads. Nonetheless, you don't ever want to give up that much edge when trading.

Competition for Orders Can Narrow Bid/Ask Spreads

Bottom line, more and more options have $1 and 0.50 strike price increments and options that may have only a few cents between the bid/ask spread. This growing trend is beneficial to the retail trader. And if a security is moving very quickly (and has narrow spreads) you may not even want to work a limit below the offer or above the bid). But you must be aware of the bid/ask spread when trading, and don't be afraid to work an order with limit prices closer to the mid-price, especially when spreads are wide.

Look at it as a % basis of the option's cost, not the $ amount…for example, 0.40 on a 2.00 option is 25%, while 0.40 on a 6.00 option is only 6.7%. Keeping in your pocket that extra $5, $10, $20, or more per contract when the pricing seems out-of-whack can add up to $100s and $1000s a year that you will be saving and go to increasing your bottom line.  And with the increased competition among market makers and exchanges, you will get filled at your good limit price much more often that you think.

Moby Waller, Co-Portfolio Manager, ETF Tradr Program & Rapid Options Income, BigTrends.com

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