Beating the Market Makers
The Smart Profits Report: Issue #212
Thursday, May 26, 2005
Beating the Market Makers: Never Pay Full Price
By Karim Rahemtulla
Chairman, Mt. Vernon Research
I want to let you in on a little secret: I beat the market makers by never paying full price. That is, I never buy options at the offer (or ask) price. Nor do I sell at the bid price.
The option market maker goons, of course, want you to pay full price - and they know that impatient investors will. But don’t fall for it. It’s a mistake.
That’s because with stocks, paying “full price” is not nearly as damaging as it is with options. With options, paying “full price” can cost you. Here’s why:
Stocks usually trade with a 1-cent spread between the bid and the ask (the price you pay to buy the stock). But options trade with a 5-cent step in the spread if the options are under $3 a share… and 10 cents if it is over $3 a share. This difference in the spread on a $3 option versus an under-$3 option is called the “rip-off spread”… well, not really, but it might as well be.
Beating The Market Maker Works Something Like This…
Say Applied Materials calls are 1.95 bid… then you can expect the ask to be at least 2.00. Obviously, 5 or 10 cents is a bigger punishment than 1 cent. At best, if you immediately sold your option back at the same price, you’d only get the bid price - and you’d be down 5 to 10 cents right away. That’s a rip-off.
And in reality, the spreads may be even wider. But even in a normal 5- and 10-cent situation, the spread is a big cost to overcome. Think about it. If the prices on a stock are $10 bid and $10.01 ask, that penny difference amounts to less than 1/100 of the stock price - just a tenth of a percent.
On an option that’s trading at $0.60 bid and $0.70 offer, the spread is 16.6%. You’re in the hole by double digits right away.
If the spread comes to 16%, then the option has to move MORE than 16% for you to just break even on the trade.
That’s not all your costs, either. Add in an extra couple percent for commissions and deteriorating time value, and you could find yourself digging out of a hole within a few hours of your purchase.
How To Buy an Option at the Right Price
So, how can you protect yourself from starting out so far in the hole and reduce some of your cost in the process? Here’s a set of rules that you should always follow:
- Never buy an option at the offer price or with a market order. Use a limit price that falls between the bid and offer. Take your time. If the underlying shares do not move then the option price will fall. If you have the time, place the order at the bid. If it is a liquid option, like a QQQQ index option, you WILL get filled most of the time. Try it - you will be pleasantly surprised.
- Never buy an option that has an expiration of one month or less, UNLESS you know that it is nothing more than a speculation and that YOU WILL lose your investment 80% of the time.
- Never pay more than $40 to ANY broker to execute a 10-contract trade.
- Even if you are going to speculate using options, take a look at the prices for options that are two or three months away from expiration. They may be more expensive, but you will have more time for things to go your way. Unless you are the Amazing Kreskin, chances are you cannot predict what a stock will do in an hour, let alone over a week or two.
If you follow the four rules of options trading above, you’ll reduce your cost, your risk - and you’ll be poised for profits.
Good trading,
Karim
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Today’s Smart Profits Cribsheet
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Check out the Smart Profits Glossary for definitions of words like “market order” or “limit price” found in today’s article.
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For more on the Market Maker series, try Smart Profits #216, Spread Trades & The Market Maker - Two Valuable Options Lessons From Boston.
Related Articles:
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How the Market Makers Lose: Uneven Trades and Open Positions
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Limit Prices: Tip the Odds on Options Trades In Your Favor
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Market Maker Survival: The Options Pit “Caste System” Revealed
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