It is often difficult to know which price to set when placing an order for illiquid ASX options. This can sometimes lead to paying too much when buying or receiving too little when selling. This is how I place my ASX ETO (exchange traded option) orders to get the best prices.
Liquid markets
If you want to buy shares or options in a liquid stock market or options market, it is nearly always possible to see the bid and asking prices placed by others in the market. You can use those “bid” and “ask” prices to set your own bid. If you want your purchase to be immediate, you can submit a bid “at market”, or limit your bid to the asking price. That way you can be pretty sure that your order will be filled straight away. If you seek a better price, you can place your bid somewhere between the bid and the ask, risking that your order might not be filled immediately. Similarly, if you want to sell immediately you could offer to sell “at market” or at the highest bid price.
Illiquid markets
When there are no bid and ask prices it can be difficult to determine exactly what price you should specify in your order. There is no price starting point from which to work. When you trade stock options in Australia, you might not always be able to find bid or ask prices. The ASX options market is often very illiquid. When there are no bid and ask prices visible, you should never place an “at market” order. That would be crazy because the counterparty then sets the price, which would probably not be the best price for you.
Market makers are obliged to submit a counter-offer within a set short time, for specified ASX options. So if you place a bid, they are obliged to counter with an asking price within a short time. Similarly, if you wish to sell and submit an order with an asking price, the market makers are obliged to submit a counter-bid within a short time. You then have a visible bid-ask basis for price negotiation.
Market maker price responses sometimes appear to be biased in their favour. For example if you seek to buy an option worth $1.56, in the absence of any price information you might start by placing a “way out” bid for $1.40. Shortly thereafter a bid ask spread might appear, showing the bid at $1.52, and the ask at $1.64. To hasten the trade you might be tempted to raise your bid to the middle price at $1.58. But in some cases, if you have a few minutes available, it might be better not to do so.
Similarly, if you seek to sell that same option worth $1.56, and “ask” $1.70, you might find a bid ask spread of $1.48 - $1.60 appears. Notice that a different spread is offered. Sometimes the spread offered will depend on whether the initial order is to buy or to sell. You might be tempted to reduce your asking price to the middle at $1.54. But it might be better not to do so if you do not need to sell urgently and immediately.
Finding a realistic price
To get an initial bid-ask price response from the market makers, you need to place an initial bid or offer to sell at an asking price. That initial price should be deliberately wide of reality.
You first need to estimate a realistic price for the option you seek to trade. There are a number of ways you can do this, including making intelligent guesses. Generally “last traded” prices are too stale. Only use “last prices” if they are a few minutes old and if the underlying share price has not changed by much. Live bid-ask prices are much more accurate than “last” prices because they are up to date right to the millisecond.
One way to determine an approximate price of the option is to look for a nearby option over the same stock for which a bid-ask is visible. Calculate a price midway between the bid and the ask. Calculate the theoretical value of that option. Calculate the difference between that mid-price and the theoretical price. Then return to the option you seek to trade. Calculate the theoretical price of the option you seek to trade, and adjust that price to account for a similar difference between the mid-price and the theoretical price. You now have an idea of a realistic price.
Placing your intial bid or ask
Your initial bid or ask price should be deliberately far from the real market price. If you are buying, your initial bid should be deliberately too low, and if you are selling, your asking price should be deliberately too high. Set your price 15% to 20% away from reality. Wait for a bid-ask response. Write it down, because it might disappear very quickly. You should assume that any bid ask spread you see is biased against you.
Adjust your bid or ask incrementally and repeatedly each 30 – 60 seconds or so. If you seek to buy an option which should be worth $1.56, and if there is no bid or ask visible, make an initial bid of, for example, $1.40. A bid ask spread of $1.52 - $1.64 might appear. Adjust your bid to $1.53 or $1.54, above the highest bid. Thirty seconds later increase your bid by one cent. Thirty seconds later increase it by another cent. Increase your bid repeatedly and reasonably rapidly, and you might find your order filled at $1.57, one cent above a realistic mid-price.
If you are selling, make an initial ask of $1.70. A bid-ask spread of $1.48 - $1.60 might appear. Adjust your ask to $1.58, below the lowest ask. Thirty seconds later decrease your ask by one cent. Thirty seconds later decrease it by one cent again. Repeat the process until your order is filled. You might find that you realise a selling price of $1.55, one cent below a realistic mid-price.
The bid – ask spread compensates market makers for providing liquidity to our markets. The two cent slippage of the example above is reasonable. It is not necessary to give away too much more than that.
Copyright © 2010 Nils Marchant, Options21.