Online Trading Academy Article of the Week
by Russ Allen, Online Trading Academy Instructor
The listed options market in its current form exists because some people are willing to make a business of being option dealers. The job of each option dealer, or market maker, is to make a two-sided market in the options of certain stocks. Making a two-sided market means that at all times the firm is willing both to buy and to sell those options.
Their computer systems continuously feed their quotes – the prices at which they are willing to buy and to sell – to the options exchanges where they operate. The market makers’ profit comes from the difference between the prices at which they buy and those at which they sell.
At one time, being an option market maker was something that could be done profitably on a pretty small scale by an individual trader using his own capital. In recent years, though this has changed so that now only bigger firms can afford the required technology. Large banks and brokerages like Goldman Sachs, JP Morgan, Barclays Bank and so on are the kinds of companies that make up the majority in this business today.
When we want to know what options are available for a particular stock or exchange-traded fund, we consult the option chain for that stock. The information for the chain is provided by a central agency called the Options Price Reporting Authority. OPRA’s computers receive the information from all market makers, other traders and option exchange, consolidate it and feed it back out again. Here is OPRA’s own explanation, from their website:
“All of the transactions executed on, and price quotations for options generated by, each options exchange are communicated to the public by OPRA… Each trade that is executed on an options exchange, as well as each price change quoted on an options exchange, is reported to OPRA as a ‘message.’ … The messages are sent to OPRA and distributed to market data vendors on a consolidated basis for use by options market participants, including retail investors, broker-dealers, and the exchanges themselves.”
We can get access to OPRA’s data through our option broker or in delayed form online through various web sites. Here is an option chain from one broker (Tradestation) in its most minimal form:
This option chain lists some of the available put and call options for the stock of IBM.
Down the middle of the screen, the “Strike” column lists different option strike prices. At each strike price (each row in the table) information for the Call (option to buy IBM) is listed on the left and information for the Put (option to sell IBM) is listed on the right.
For each individual Call or Put option, the Bid column shows the level of the highest limit order to buy that exists at that time for that option (consolidated from worldwide data by OPRA). In the first set of options above, July 2015 for example, the number in the green column under “Bid” for the Call at the Strike of 170 is $6.60. This means that in the whole world at that moment, the highest price at which anyone had committed to buy that option was $6.60. This quote might be from one of the market makers for IBM options. It might also be from some other institutional trader or even a retail trader like us.
The “Ask” column shows the lowest price at which any trader anywhere has committed to sell the option. For our July 170 call, the Ask is $6.80. Again, this quote might be from anyone, including possibly (but not necessarily) the same market maker who is simultaneously bidding $6.60.
The market maker’s profit comes from buying at the Bid price and selling at the Ask price. Our July 170 call provides a $.20 profit margin ($6.60 vs $6.80).
Notice that we see a fully populated matrix here, with no holes. Every option has both a Bid and an Ask price. This is true whether there have been any actual trades on a particular option or not. The reason for a complete and fully populated chain at all times is that the market makers are always quoting every option whether anyone else is or not. They literally make the market.
If many other people aside from the market makers are also interested in buying and selling a company’s options, they of course will be placing their own orders. If they want to buy at a price that is a touch higher than the Bid price shown, they are free to place a limit order to buy accordingly. If we wanted to buy some of those July calls for example, there is nothing stopping us from placing a limit order to buy at $6.65, $.05 more than the current $6.60 bid. We then become the best bid, rather than the market maker. We are in line in front of the market maker, and he will get less business. If he wants to get more he will have to raise his bid. This will narrow his spread. The same thing is true in reverse for Ask prices. If the market makers are quoting a high price others are free to offer to sell at lower prices. Again the market makers will have to narrow their spreads to compete.
In stocks where many thousands of traders participate, the bid-ask spread can narrow to as little as a penny. This is the case, for example, on options of heavily traded index exchange-traded funds like QQQ (NASDAQ 100 index fund) or SPY (S&P 500 index fund).
As a general rule, the narrower the spreads on options are the better it is for the retail traders like us. That spread is the markup between wholesale and retail. Friends don’t let friends pay retail. In our Professional Options Trader class we teach our traders always to look for narrow spreads and to give options with wide bid-ask spreads a pass. I suggest that you also follow this example.
The example above was the most minimal useful form of the option chain, which looks like this (repeated from above):
The chain above shows only the Bid and Ask prices for each option. This is the minimum amount of information we need in order to trade. It shows us at what prices we could buy or sell each option.
There is additional information that is included in most option chains. Here is a typical presentation:
We now have more information. Here is a capsule description of each item:
Imp Volatility: The rate of expected future price movement of the stock that is built into the option’s price. For the June 170 calls, for example, this is 8.06%. That means roughly that the current price of the option (the midpoint between the bid of $3.50 and the ask of $3.65) indicates that option buyers and sellers expect IBM to move at a rate, between now and the option expiration in 21 days, that if continued for a year, would result in a range that is centered around the current price of IBM, but could be as much as 8.06% higher or lower. The more people are willing to pay for this option, the higher the implied volatility reading will be.
The relationship between option prices and implied volatility is defined by the option pricing model, or formula, that was published by mathematicians Black and Scholes in 1973.
Note that there is a separate Imp Volatility value for each individual option, and that they are different from each other. This difference in implied volatility from one option to another doesn’t really mean that the buyers of different options expect different amounts of movement for the same stock. It is actually an indication that the part of the Black-Scholes option pricing formula that relates implied volatility to option prices is flawed, with respect to options whose strikes are far away from the current stock price. The formula assumes that these far-away prices are less likely to be reached than they really are. So the market (real live humans who buy and sell options) votes with its prices accordingly.
The Implied Volatility figures for all of the separate options for a given stock are aggregated together into a weighted average, which is referred to as the implied volatility of that stock. We can chart implied volatility for the stock over time. We can then say something about the current level of implied volatility compared to its observed levels over that time. If the current level is high, then we conclude that people are currently paying high prices for the stock’s options – maybe too high. We’d then want to look for opportunities to take advantage of this overpricing by selling that stock’s options short. If on the other hand we found that the current level of implied volatility was unreasonably low, then we’d be more interested in buying that stock’s options, rather than selling them short.
Volume: This is the number of options that changed hands today. We’d prefer this number to be consistently high: at least in the hundreds of contracts per day for the most popular options (the ones with strike prices near the current stock price). If there is low volume in the options for a stock, then the option market makers will have little competition and will quote the options with a wide bid-ask spread. That spread is a cost to us, and we want it to be small.
Open Int: This is Open Interest, the number of option contracts that are currently outstanding. This number is constantly expanding and contracting. As the demand for a stock’s options increases, new option contracts are created to fill the need, causing open interest to increase. When more option trades are being closed than opened, then the total open interest goes down. Most options that are created end up being closed out before they expire.
Like volume, a big number for Open Interest indicates a lot of activity in this company’s options, which probably means that many traders are involved. Once again, that means competition for the market makers, which causes their spreads to be narrower than otherwise. We’d like to see the open interest on the near-month options in the tens of thousands when all of the strikes are added up. Otherwise, the stock is not suitable for us to trade.
Next time we’ll look at the other elements of the option chain – the Greeks. Until then, remember to stick to options with large numbers for open interest and volume, and small bid-ask spreads.
For comments or questions on this article, contact us at [email protected].
Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission from Online Trading Academy, e-mail address above.
