Wednesday, April 07, 2010

Efficiently trading options




Before we get into definitions of what we mean, let us clear up what we are about to discuss. Trading options efficiently means knowing the marketplace, the players and how they act.
For some reason, people who have money like to buy things, and then watch them go up in value. For that reason, it is usually easier to explain things in terms of buy, increase, sell. So we shall use long call options as our vessel to explain things. All the principles we explain, as will be evident will also apply to selling options. As option spreads just consist of the simultaneous purchase and sale of different options, the ways of efficiently trading long calls, will be no different for any other kind of options position. So much, initially for the market.
Now let us look at the players. First, there are we, the retail trader; then there is our counterparty the market maker/specialist or whatever they are called. Institutional investors are not of any interest to this discussion: they might be important in deciding what options to look at - for example, because of unusual options activity in an underlying - but what we are discussing here is how to efficiently trade options that you have already decided to purchase for whatever reason; the actual reason is not relevant.
Before we look at the games that market makers play, here are the first 2 rules of efficient options trading:
1. If you cannot find an option that is efficient, pass on the trade. There is always another one somewhere, and if there is not, then sit on your hands, and keep your powder dry.
2. Do not go long options when the recent implied volatility is high compared to what it has been in the last 20 days.
There is a place where we shall talk about the greeks, at which time we can explain rule 2. Now we need to know what we mean about rule 1.
The Market maker/specialist
This is always your counterparty. You do NOT trade with other traders; you and all other traders trade with the market makers, however they are designated.
If we look at how the market makers are defined, this is what we get: "The market makers provide a required amount of liquidity to the security's market, and take the other side of trades when there are short-term buy-and-sell-side imbalances in customer orders. This helps prevent excess volatility, and in return, the specialist is granted various informational and trade execution advantages.
Other U.S. exchanges, most prominently the NASDAQ Stock Exchange, employ several competing official market makers in a security. These market makers are required to maintain two-sided markets during exchange hours and are obligated to buy and sell at their displayed bids and offers. They typically do not receive the trading advantages a specialist does, but they do get some, such as the ability to naked short a stock, i.e., selling it without borrowing it. In most situations, only official market makers are permitted to engage in naked shorting."
How altruistic of these kind folks? How can I put this delicately, to disabuse your minds of any such claptrap? I know: "That is a damn, blasted lie! The market makers sole purpose it to take the money out of your pocket and put it into his." There are many tools that are used. The major one, since it affects underlying equities, is the market maker's book. Imagine that you are negotiating a purchase of a car and that the dealer can see beforehand the maximum price that you will pay, quite apart from the offer that you have made. That is the market maker's situation: he/she can see your orders, and your uncle-point order. If there are enough orders clustered with yours, he/she will manage to drive the market there to take advantage of all those orders just sitting there to be executed. What is his main tool to move the market? The bid/ask spread. By adjusting the bid/ask spread, the market maker can continually make one side more attractive than the other. Once we understand how they manipulate the bid/ask spread, and what they do when they take your option order, we can start to think of how to achieve efficiency.
Buying and Selling
Before we actually look at how the market is driven, we need to look at what it means when we buy and sell that call.
The market maker, generally will sell at the ask, buy at the bid. We must then needs be doing the opposite. So, a retail trader buys at the ask, and sells at the bid.
What does this mean? Let us look at an example. The SPX May 2010 1185 Call option has a bid price of 24.30 and an ask price of 26.30. Assume that you buy this option. You have to pay 26.30 for it. Let us assume that you instantly think you made a mistake, and have to sell. You must sell at 24.30, losing $200 just for entering the position. Unfortunately, when I give this example, I often get a response which says: "Well, yes if I had to exit immediately, that might be a problem, but not if I held it." To say the least, this is a shocking response. What in the blue hell does it matter how long you hold it? BEFORE YOU CAN MAKE A PROFIT, the bid price (at which you are going to sell) MUST rise above the 26.30 at which you bought the option. In other words, the bid must travel from 24.30 to 26.30 before you break even (sans commissions). This has nothing to do with how long you hold the option. If you hold it for 1 minute, or 3 weeks, the bid must be higher than the ask at the time that you bought the option. To put it simply you MUST overcome the bid/ask spread of 2.00 BEFORE you can be profitable, no matter how long you hold the option.
The option penalty
The preceding discussion means that every time you buy an option, you are in effect paying a penalty to be in the trade. This penalty is the bid/ask spread. There is more than one way of looking at this penalty. Many folks like to look at it as a fraction/percentage of the cost of entry, and use that to make a decision. So, in the example that we gave, the penalty for entry to the trade is 2.00 divided by 24.30, or roughly 8%. Some will just look at it in absolute terms and say $200 is $200. Before you make the trade, you need to ask yourself: "How many people do you know who even earn $200 an hour, and how many trades do you make that make 8%?" And please remember that is the penalty that you pay up front!
Trading efficiently
This then points us to the way to trade efficiently. Minimize the penalty of entry. Just keeping this alone in mind, means an immediate jump in efficiency. However, to do this, we need to understand what our counter party, the market maker is doing, and why.
What happens when you buy a call is pretty much always the same. If you buy a call, then it means that the market maker sold the call. For most firms, within 5 seconds, he will purchase stock to hedge the sale to you. He now effectively has a covered call. When we come to sythetics, we shall find that he is effectively short a naked put. (Incidentally, despite how hard options pundits try to make synthetics look complex, the reality is that instead of memorizing all the various combinations, a tendency that the USSA education system seems to create, you only NEED to understand ONE equation and ONE axiom, to be able to synthesize any position, most of the time without even using paper to write anything!!! I promise that when I teach this, those of you who choose to understand rather than memorize may well be shocked at how easy it is to synthesize positions using options and stock.) Why does the market maker buy stock instead of creating a spread by buying a different option? Because stock has only delta, by using stock, he immediately captures the extrinsic value of the option (the amount by which the option price exceeds the difference between the stock price and the option strike price). Stock value is not directly affected by volatility considerations. Let us not turn this into a lesson on the greeks, so let us leave this here.
Someone else sells a call, the market maker goes short to hedge.
This goes on all day. At the end of the day, the market maker balances his books, mostly by boxing spreads and determines his net position. If he is net long, he will usually hedge, either by shorting stock, or preferably, buying put options, usually on the SPX or SPY. (Just as a side note, note the effect this has on the VIX. If the herd is short, the market makers are long, and buying SPX puts to hedge. So now you know why the VIX rises when the herd is net short).
Let us get back to the efficiency question. If the market maker is unbalanced at any time; maybe a sudden spike in activity, he will try to buy time to get balanced by slowing the action. Assume that the herd suddenly starts buying. As he gets more and more short, he wants to slow the buying, so he ups the ask and holds the bid. This means automatically that the bid/ask spread widens, so more savvy investors stop buying because the bid/ask spread is too wide. Some more of the herd simply stop buying because the ask is above the price that they wish to pay. Regardless, because the bid/ask spread has widened, the penalty of entry also increases, and all of us who have now read this will also join those sitting out (hopefully). Regardless, the buying slows. Now to increase selling, he will bring up the bid, or lower the ask, depending on whether he wants the price to go relative to his large option position. Generally the price will be driven to just where the most options will expire worthless, giving the market maker the full value of the extrinsic value of all sold options. If you buy out of the money options, he makes a profit on the stock too!! Now you know why options get pinned at expiration!
In other words, the market maker is signaling his willingness to trade, by the size of the bid/ask spread. The narrower it is, the more interested he is in trading, so the easier it is to get in and out. In effect, the liquidity of the market is really a function of how eager the market maker is to trade off his position. The net effect of all this then is that the narrowest bid/ask spreads will generally be at the options with the highest open interest (where the most contracts are open). Now you know why most good options traders look at open interest.
So now, we come to the same rules that you may have seen elsewhere. Now you know why you should use them.
1. Trade options with a narrow bid/ask spread. Best are those with penny wide spreads, as you can generally become the market maker on those, buying at the bid, selling at the ask, as the normal noise of the market will put you in. The narrower, the bid/ask spread, the smaller the penalty. For example the penalty to trade the SPY May 2010 118 Calls is 0.01 (the spread) divided by 3.05 (the bid), 0.33%, or $1 ! The narrow bid/ask spread CANNOT be emphasized enough. It is the single most important thing when you trade options. I generally will not trade any options that have more than a 0.10 bid/ask spread; just occasionally, I will trade a 0.15 spread. What if I cannot find any options with a narrow enough spread on what I want to trade? I pass on the trade.
2. Trade options with high open interest. Generally, this is because with so many contracts open, the market maker's position is more likely to be unbalanced. He wants to balance out his position, which gives him an incentive to trade. In point of fact, a narrow bid/ask spread will also most often be at the options with the highest open interest anyway.
3. If you are long, trade an option that moves. A slow moving stock will eat away your extrinsic value. We are not yet talking about the greeks here, so let us just leave this as a rule with no explanation.
4. If you are long, trade options with low implied volatility. This again is a matter of the greeks, which we shall tackle at another time. They are not as complex as some make them sound.
Bang for the buck
There are really only three option trades: (looking at calls for now)
1. In the money. The option strike price is less than the price of the stock.
2. Out of the money. The option strike price is higher than the price of the stock.
3. At the money. We shall be liberal and say that ATM consists of the 2 nearest strikes to the price of the stock, on each side.
Many ask which to trade. There is no real answer. It depends on what you want to do.
In the money options are the safest as they already have a real value at least equal to the difference between the option strike price and the stock. If the stock stagnates, all that is lost is the extrinsic value.
Out of the money options are the least likely to be profitable, as they have only time value. This means that your analysis must be spot on as to where the stock is going, and the stock must get there fast. You want to buy the option with a strike that is just inside where you expect the stock to go.
At the money options give the most bang for the buck, striking a balance between one's chances of the stock moving in a favorable direction and the amount of extrinsic value.
Note that because ATM options have essentially a 50/50 chance of being in the money, they also have the highest uncertainty, and so the highest implied volatility. OTM options are known to be likely out of contention: ITM options are likely in contention. It is the ATM ones that are chancy, so once again, you see that is where the market maker keeps things bad for the retail customer.

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