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The Options Bid
The Smart Profits Report: Issue #279
Tuesday, January 31, 2006
The Options Bid - “The Bid, the Bid, Always the Bid”
By Steve McDonald
Advisory Panelist, Mt. Vernon Research
The legendary Vince Lombardi won five national football titles as head coach of the Green Bay Packers. And the most common challenge he faced was dealing with the injury list… “The knee, the knee, always the knee,” he lamented.
It’s safe to say that anyone who has played professional football has some type of knee problem. Considering the nature of the game, it’s almost unavoidable.
Like knee injuries to a football player, all options traders have at some point lost money to a common “injury” - a profit-eating “option bid.”
Knowing what an option will sell for, or getting what an option is worth, is one aspect of option trading that may require the most finesse. Let me explain…
Close the Bid Spread With Limit Orders
Forget the “ask” and the “last.” Once you own an option, the only number that counts is the bid. The money you will realize is the amount quoted in this price.
Unfortunately, the bid is also the one value that market makers can - and will - manipulate to profit the most. The less they pay you at the bid, or the wider the spread, the more they make. So, it is a “them” against “us” situation. And you might want to look at it that way if you plan to make money at this.
Take a look at two options I’m following at this writing (please note that these are not recommendations):
1. The February 2006 $15 put options on Oakley, Inc. (NYSE: OO). The stock is trading around $15, and the option quote is as follows:
Symbol: OONC
Last: .55
Ask: .55
Bid: .40
2. The February 2006 $37.50 call options on Agilent Tech, Inc. (NYSE: A). The stock is trading around $35. And the option quote:
Symbol: ABUX
Last: .55
Ask: .50
Bid: .45
Here’s why 90% of options lose money…
A novice looks at these quotes and pays .55 for the Oakley option and .55 for the Agilent option. He’s already down 37% on Oakley and 22% on the Agilent. The options are only worth the bid, so you’re in a hole even before you start.
The Last Thing You Want to Forget
If you learn nothing else about options this year, remember this: Use limit orders. It’s the only way to bring some pressure on the market makers to be reasonable in their spreads and the only way to avoid falling into their trap. When rookies buy or sell options at the market, large red signs flash on the exchange floors that say, “SUCKER.”
If a large number of buyers make offers at .45, instead of .40, the market maker may change the bid to fill the orders. In this case, we have affected the market. But, if folks are willing to accept the lower price, why should the market maker change anything?
Offering options for sale at .45 or .50 may take more time, but it’s the only way to close the difference between the bid and the ask.
The larger the order, of course, the better the chance of getting your price. If you’re trading five and 10 contracts at a time, you’re at a disadvantage. The big boys always have, and always will, get the deals. That’s why using a full service broker will help you with this (see today’s Crib Sheet for more on full service brokers).
Will you always get your price with a limit order? No. But when it does go in your favor, you make more money. And that’s really the game.
Why did Vince Lombardi win as much as he did at Green Bay? Injuries may have hobbled the team from time to time, but discipline was a hallmark of Lombardi’s winning ways. None of his players had good things to say about him during training camp. He was a tough taskmaster. But discipline wins football games.
Discipline is how you win at options, too. Learn the discipline of using limit orders, study how the market makers play with the spreads, understand how to use the information in an option quote, and win more often.
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Today’s Smart Profits Cribsheet
- Today’s report offers details about the options buying process. Smart Profits #261, How to Get the Best Price on Your Options, explains the three major benefits of using a full-service brokerage firm when dealing with the options markets.
- Check out the Smart Profits Glossary, chock full of over 150 option terms, like “option bid and ask” and “limit order” found in today’s article.
- Get a market maker’s perspective! Lee Lowell, fellow Advisory Panelist of Mt. Vernon Research, spent seven years in the options pits of the New York Mercantile Exchange as a market maker. He’s put together an entire series for the Smart Profits readers - #241, #243, and #247.
Good Trading,
Steve
Related Articles:
- Using a Probability Calculator - Know Your Trade’s Exact Chance of Success Up Front
- How to Increase Your Options Understanding Ten-fold
- Liquidity & Limit Orders - An Options Balancing Act
