It Pays To Get Tight On Spreads

The inherently large bid/offer prices quoted for many options including the Euronext equity options turns many retail traders off. But even though the spreads are often wide it’s normally always possible to tighten them up and get a fair dealing price.

You might only save a point or two, but do this on every trade and that's a lot of money at the year end.

Option market makers generally quote wide prices because they follow far too many different options to be able to update their prices all the time. But they will normally quote a tighter price if a trader starts to quote against them. For example –

• You’re interested in buying an option that is quoted at 70 bid - 80 offered
  
  
• Of course you can get a guaranteed fill if you pay the offer price of 80 but why not use some intelligence and play the game as it's supposed to be played
  
  
• Make the assumption that you won't be able to buy below the mid price of 75, so now you can tighten the market to 75-80
  
  
• But it's still unlikely that you'll buy at 75 because normally with all options you normally have to give the market maker a point or two
  
  
• This is the market makers edge and in most circumstances he would sell his mother before giving it up!
  
  
• So to buy your option with the market currently 75-80 it would be good advice to bid 76 for a moment and see what happens
  
  
• If no trade, then bid 77 and finally 78 where in most scenarios apart from when the market is very volatile, you should get filled

This process seems complicated but if you’re broker provides good online software it’s easy to play these sorts of games. The moral here is to play with the bid/offer spread as well as play with your competitors in the market, because they’re playing with you...

When To Hit The Bid or Offer

There are however times when it's not a good idea to get too clever, and just trade at the market.

When the underlying gets very volatile you are often best advised to buy or sell at the market. Much money has been lost over the years by people trying to get too clever and save a few points in situations such as this.

So as a rule of thumb, always strive to get the best price in normal markets but when volatile deal at the market. This of course assumes the quote you’re being offered is not outrageous.

Conclusions On Options

To fully understand options and trade them successfully you've got to work at them.

They can be hard to understand at first but in reality any options strategy can understood by breaking it down into the individual options, seeing how they will perform in different market outcomes and then building the strategy back up.

Also don't fall into the trap of thinking that options will make you money if you study them enough, they won't. What will make you money is your view on the underlying share or index. Therefore it's always good advice to spend at least 80% of your time on researching the market and only 20% on the best option strategy to use.

Learning by doing is the best advice with options. Start making small transactions and learn from your mistakes. Doing it this way will probably teach you far more than learning from a text book.

Finally never ignore the importance that volatility plays in the pricing of options. As I've mentioned time and time again, let volatility be your road map when deciding what type of strategies you should be trading.

If volatility is high then you should lean more towards the selling or writing of options, but if volatility is low then buying options can often pay large dividends.

Good luck with your Options trading and if you need any help don’t hesitate to contact me - Alex Green.