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Market Maker Bids
The Smart Profits Report: Issue #191
Monday, March 14, 2005
Market Maker Bids: Outmaneuvering the Market Maker’s “Hidden Bid”
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
Sometimes you might wonder who really regulates the options markets. Oftentimes, an option that is out of the money and not very liquid trades at a wide spread of zero on the bid and some amount, say $0.25, on the offer. What is the point, you may ask, of even having such a spread - or even a quote?
The market is telling you that the chances of the underlying stock moving to the strike or higher before expiration are zero, zilch, nada!
But wait… When you try to buy the “worthless” option at some ridiculous price, say $0.05, something strange may happen: You may be joined by a market maker on the bid. This happens sometimes with covered calls…
A Covered Call Bid Snafu - By A Market Maker
For example, let’s say you bought a stock at $20 a share and sold the July 2005 $22.50 calls for $1.
Then the stock goes down, and you wind up a month away from expiration… Now you look at the option’s current price and you notice that it is bidding $0 and offering $0.20. What this means is that you can buy the options for 20 cents and, if you sell, you get nothing.
However, if you decide that you want to close the position early and sell a further dated call, you could pay $0.20… or you could put in your own bid. Let’s say you decide to put in a bid at 5 cents.
All of a sudden, you will find out that you are not the only one who just “upped” the bid from $0.00. A competing bid could suddenly appear: The market maker’s!
Now, why is he seeking to buy the options at a higher price than he was just advertising (zero on the bid)? Is it just coincidence that his bid appeared at the EXACT SAME time as your order? Could you both be clairvoyant and know something about the market that nobody else knows?
The Hidden Bid and You - Two Traders Aiming to Cover
The answer is no. What happened was that there was a secret bid there all the time - just not advertised. It existed in the market maker’s head - that elusive “inside market” that exists for all securities (more on this at a later date). But it just was not shown.
The market maker, who is looking to buy the same options, may be short the options, like you - i.e. he sold the call to hedge his stock position. He is looking to cover a month early (he is, as they say, “buying to cover”) for a nickel a contract, just like you.
Why? Well, if you can cover a profitable trade at next to nothing (or a nickel) then you can close out the position early - and actually benefit if the shares move higher and you are able to re-sell the option.
So when you put in an order to buy the options at $0.05 for 40 contracts, another 45 could very well show up at the same price on the same exchange.
Guess who is going to get filled first? There oughta be a law!
How To Turn the Tables On The Hidden Bid
But here’s the good news… This “hidden bid” phenomenon works not only in the market maker’s favor; you can make it work in your favor, too.
If you are trying to sell an option with a bit of time left - be it a call or a put - that isn’t close to the strike price, you may see a ridiculous spread. You may say to yourself: It is not worth selling because the bid is zero or a nickel.
But if the spread is, let’s say, $0.05 by $0.40, you should enter an order at $0.15 or $0.20. And you just might get filled… because there could be a “hidden bid” waiting to snap up your offering.
And that’s how you use the market maker’s own “advantage” against him… a rare but satisfying occurrence.
Good trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definitions of terms like “out-of-the-money,” “hedging,” or “maker maker” found in today’s article.
- For more on the Market Maker series by Lee Lowell, check out Smart Profits #205 , Market Maker Tactics: What Market Makers Really Do.
Related Articles:
- Options Market Makers: Two Rules for Beating the Market Makers
- Out of the Money Options - Buyer Beware, Seller… Take The Money
- Hedging & Speculating: How to Enjoy Guaranteed Monthly Income With Options
