Alan Ellman, of TheBlueCollarInvestor.com, goes beyond just the three required skills for option trading to discuss a fourth, less apparent skill, negotiating a better price with the market maker with the Show or Fill rule, also known as the Limit Order Display rule.
Covered call writers generate cash flow by selling call options associated with a stock or exchange-traded fund. Our goals are to generate the highest possible returns with low-risk trades and that fit our requirement for capital preservation. The three required skills for achieving these goals are stock (or ETF) selection, option selection, and position management (exit strategies). In this article, I will discuss a fourth, less apparent skill, negotiating a better price with the market maker.
Market makers generate profits from the bid-ask spreads…the greater the spread, the more money they make. From their perspective, they want to buy as low as possible and sell as high as possible. To protect retail investors from large spreads, the SEC has established the Show or Fill rule, also known as the Limit Order Display rule, or technically, the Exchange Act Rule 11 Ac1-4. This regulation requires market makers to show or publish any order that improves the current bid or ask prices unless it is filled. Any order between the bid and the ask will improve the market.
When the spread is small, say $2.50 – $2.60, we don’t have that much to work with. But what if the spread was $2.50 – $3.00? If we placed a market order, we would most likely get filled at the bid price of $2.50 and there may have been an opportunity lost. Instead, let’s leverage the Show or Fill rule: Find the mark or mid-point of the bid-ask spread and drop down slightly in favor of the market maker and place a limit order at that price. In this case, the mark is $2.75. I would place a limit order to sell the call option at $2.70, not $2.50. Now the market maker is faced with a dilemma…execute our trade for $2.70 or publish the new spread at $2.50 – $2.70. The $0.50 spread now becomes a $0.20 spread. It is now in the hands of the market maker. In many cases, we will get executed at $2.70 and the published spread will remain at $0.50 as we pocket an additional $20.00 per contract. Covered call writers are in the business of selling options. These $20.00 bonuses will add up over an investment lifetime.
Real-life example as of market close 4-17-15
Click to Enlarge
Bid-ask spread for AKRX
- Spread: $2.00 – $2.35
- Mark: $2.17.50
- Place limit order to sell covered call at $2.15
One more thing: Our trade execution forms have an All or None (AON) box. Do not check this box. If we do, the market maker is no longer obligated by the Show or Fill rule.
By Alan Ellman of TheBlueCollarInvestor.com
