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Why is the Market So Wide On Options?

Some days, it feels like you're just getting screwed.

You get bullish on a stock, so you put an order in to buy a call. The bid/ask spread is .50 wide, which means if you use a market order you're already down $25 against the mid.

Instead, you opt for bidding at the mid... but no fills. Instead, a rush of orders come in exactly at the price you wanted. And they end up getting filled before you!

While you're sitting there for a fill, the stock ends up taking off without you. And a missed opportunity can feel just as bad as a losing trade.

The Stock Is Wide So The Options Are Wide

Many times, the option market is very wide because the stock market is very wide.

Take an example like AMZN. At the time of this writing it's trading in the 500s which is pretty high relative to most of the market. Keep in mind, this doesn't include considerations like market cap, just that a single share will cost you $500.

Here's a look at the order book of AMZN:

amzn-depth-of-book

This was taken at the open and the market was pretty thin to begin with... but let's use these quotes as a jumping off point.

Say you went out and bought an at the money call at market, which guarantees a fill at whatever the asking price is. Because the call is ATM, it's going to have a delta of 50. This leaves the market maker net short 50 shares.

In order to balance that exposure out, the market maker can either use other positions on their book, or they can go buy 50 shares of stock on the open market.

The market's bid/ask is 544.35 x 544.87. That means the spread is 0.52 wide. And that's only on 2 lots to the bid and 1 lot on the ask. If you had to buy 500 shares at what the market is currently showing, that last round is 544.02 on the bid and 545.88 on the ask-- a spread of 1.86.

This calculation assumes that there's no hidden liquidity (which there is) or that more bids won't step up (which they will).

Go back to the market maker with a net exposure of -50. If they were to immediately get flat using a market order, they're already at a $26 disadvantage in the market just due to slippage.

In order to adjust for that slippage, the market maker will only put quotes out at levels that compensate for the slippage in the stock market.

You'll see this more on large priced stocks like AAPL CMG AMZN and NFLX. And it becomes even more pronounced on stocks that don't trade much volume to begin with.

If you're seeing a not-so-liquid options market, it's probably because the stock liquidity isn't that great either.

Markets are More Inbred

With more and more algorithmic trading, you end up with the robots trading against each other in the same markets.

On the stock side, two great examples are SIRI and AMD. They are both large companies, but the stocks trade under $5. And they trade 10s of millions of shares per day.

I have a suspicion that the overall order flow is not due to large institutions getting in and out of the stock, but algorithmic trades using a combination of market microstructure and exchange rebates to milk the market.

We then end up with stocks that generate liquidity inbreeding.

Same thing happens in the options market.

The popularity of certain stocks and etf's mean that 80% of the liquidity is in 20% of the market.

It ebbs and flows, of course. I remember back in 2007 during the big commodities boom ag stocks like POT, MOS, and MON were all the rage and had super liquid markets.

Right now it seems that most of the liquidity for options are in high beta tech stocks.

The liquidity inbreeding becomes even more pronounced when we look at options duration.

Everyone and their mother now trades weekly options. Some people like them for the amount of leverage you can get relative to total capital, others like how fast the theta comes in.

This ends up leaving longer duration options as a ghost town

What You Can Do About It

The first thing you should cut out is whining. If you think you're going to get screwed by the market, you get screwed. It becomes a self-fulfilling prophecy as it affects your psychology and how you approach risk.

Embrace the matra of "it is what it is."

If you don't want to follow the liquidity and trade weekly options, here are some tweaks to your trading to consider.

Trade Like a Market Maker

Instead of forcing trades, you can let the market come to you. Odds are if you're chasing a stock higher, it'll come back to your original price just given the natural volatility of the stock.

If you're trading option spreads, you should figure out the price given certain conditions and float orders out accordingly.

Change Your Execution Strategy

Novice option traders treat the market as an "all in, all out" kind of scenario. I think you can get a better edge through use of scaling in and out, taking advantage of the wide bid/ask spreads and the natural volatility of the market.

Believe it or not, there is liquidity in wide options especially if you are selling risk.

Think about it: if you are an institution with a ton of size in a stock and you want to hedge, you don't really want to use weekly options because they only give you 5 days' worth of hedging. There's demand in longer dated options if you are willing to step up and sell that risk.

Use Liquidity Pings

This is very useful on very wide markets like cash settled indexes (SPX, RUT, NDX).

When the bid/ask is really wide, the only way to find the true price of the market is to probe for it. If you put an order out and it's immediately filled, then try for a better price on your next round.

But if nobody is filling your order, you may want to consider walking the order until you find a fill. If the price isn't what you want then you'll want to consider avoiding the trade or using a different option strategy.

by Steven Place

Steven Place is the founder and head trader at investingwithoptions.com/