Some fundamental questions about option trading

[blackice 5]

Hi Kim/everyone,

I have some fundamental questions about how option price is calculated in CBOE quotes, would you please help?

 

1. Does "Days To Expire (DTE)" only count trading days, or it counts every calendar day (including weekends and holidays)?
2. When option price is calculated within the SAME trading day, is DTE an unchanged integer number, or it changes with time goes forward (a float number changing as time goes)?
3. Where to find interest rate (risk-free rate) that I can use in option calculator to generate the same price as our trading platform does?
4. For SPX option, what condition(s) will cause bid/ask diff to enlarge, and vice versa?
5. For SPX option, why mid price can always make the deal succeed, but slight different price won't?

Thank you!

Edited November 27, 2016 by blackice

[Kim 7,513]

8 hours ago, blackice said:

Hi Kim/everyone,

I have some fundamental questions about how option price is calculated in CBOE quotes, would you please help?

 

1. Does "Days To Expire (DTE)" only count trading days, or it counts every calendar day (including weekends and holidays)?
2. When option price is calculated within the SAME trading day, is DTE an unchanged integer number, or it changes with time goes forward (a float number changing as time goes)?
3. Where to find interest rate (risk-free rate) that I can use in option calculator to generate the same price as our trading platform does?
4. For SPX option, what condition(s) will cause bid/ask diff to enlarge, and vice versa?
5. For SPX option, why mid price can always make the deal succeed, but slight different price won't?

Thank you!

1. Calendar days

2. Market makers usually adjust the prices intraday especially when the options are close to expiration. For example, if you look at prices of options on Thursday for the next day expiration, the price will be definitely different at the open and at the close (assuming all other factors equal).

3.As for all options (not just SPX), the bid/ask will widen during fast moving markets, before important events (like Fed meeting etc), and in general, when market makers feel that the risk and uncertainty are higher than usual.

4. Mid price not always gets filled as well, sometimes you need to give up few cents. Again, it depends on market conditions.

[blackice 5]

2 hours ago, Kim said:

1. Calendar days

2. Market makers usually adjust the prices intraday especially when the options are close to expiration. For example, if you look at prices of options on Thursday for the next day expiration, the price will be definitely different at the open and at the close (assuming all other factors equal).

3.As for all options (not just SPX), the bid/ask will widen during fast moving markets, before important events (like Fed meeting etc), and in general, when market makers feel that the risk and uncertainty are higher than usual.

4. Mid price not always gets filled as well, sometimes you need to give up few cents. Again, it depends on market conditions.

Hi Kim,

I thank you sincerely for the answers! A few more points to clarify:

1.  Does term "market makers" you use in (2) and (3) refer to the same? In (2) it sounds like brokers, but in (3), I thought bid/ask prices are purely based on participating traders' orders; can brokers affect it?
2. DTE is calendar days, then that means, if we fill a +theta and -delta position (like iron condor) on Friday morning, then on Monday morning, the time passed for three days but trading was only one day. This is good for such position since we want time to pass without much price move. Is my understanding correct?
3. For "Market makers usually adjust the prices intraday especially when the options are close to expiration", is there any way to find out the DTE parameter that market makers are using for current moment?
4. If orders usually get filled at or around mid prices, then the bid/ask should reflect that (since there are many limit orders at or around mid price). But why that's not the case...

Again, I truly appreciate your fast answering to my beginner questions!

 

 

 

Edited November 27, 2016 by blackice

[Kim 7,513]

@blackiceYou are welcome, this is the purpose of the forum.

 

1. Market makers and brokers are different things. Brokers (like IB TOS etc.) are responsible to execute orders. They make money mostly from commissions they charge you and me. Market makers are responsible to set prices. Here is a good description. They make money mostly from the bid/ask spreads - this is the reason why you rarely can be filled at the mid. You need to pay above the mid to buy and below the mid to sell.

 

2. What you refer to is called weekend effect. The short answer is no, you cannot get 3 days decay in one day, otherwise it would be free money (which as we know does not exist). Here is a good explanation of weekend theta. MMs start to "adjust" the prices around Thursday to reflect for the weekend, so the price difference between Friday close and Monday open will be 1 day of time decay, not 3 days.

 

3. We have no way to know how exactly they do it. I believe they use some kind of "secret formula" and it's all based on algorithms.

 

4. Well, you need to know what is the "real mid". For example, if MMs think that options fair price is $10.00, they might set the bid/ask at 9.70/10.30, so the mid is 10.00. Now comes your order at 10.00. The bid/ask moved to 10.00/10.30 for few seconds (or even less), but the real mid might remains at 10.00 - this is where the fair value of the option is. And this is why you might get filled at 10.00 even if you see 10.00/10.30 for few seconds.

 

 

[blackice 5]

Thank you again, Kim, for the generous offering of knowledge. Based on some more research, here is my understanding of Market Makers and bid/ask prices, please see if it's correct:

First, MMs are not any special than retail traders like you and me; they obey the same rules as us and do no more than sending orders to exchanges with certain prices set.

Second, their orders are usually large and therefore stay longer on quoting board (unless they change their orders). This is because, 1) orders with prices off their bid/ask prices are comparably small, and get filled quickly, so those prices show (if there's a chance) on quoting board for a short while, 2) orders with prices equal to their bid/ask prices are usually smaller than their orders, so their orders are usually partially filled, so quoting board still remains showing their prices. This seems like "setting prices", but not because they have special power, rather, because their orders are large enough.

Third, our (retail traaders) orders can be filled at/around mid price, is because our orders get filled with other retail traders' orders, who are trying to buy/sell options with fair price (which is mid price). But again, since our orders are small, and get filled quickly, their prices are not staying long on quoting board.

Fourth, MMs set their bid/ask prices based on some complicated hedging strategies (since their portfolio is large and complicated) that limit their risk and guarantee some profit. Their orders are filled usually when some party (trader or institute) send a large order at or close to their bid/ask prices, since these orders cannot get fully filled around mid-price due to their large sizes.

Please point out if I'm misunderstanding any part.

Again, I'm so happy to learn knowledge so fast on this forum. This made me much happier than get some gains blindly. I'm recommending it to my friends.

[cuegis 683]

5 hours ago, blackice said:

Thank you again, Kim, for the generous offering of knowledge. Based on some more research, here is my understanding of Market Makers and bid/ask prices, please see if it's correct:

First, MMs are not any special than retail traders like you and me; they obey the same rules as us and do no more than sending orders to exchanges with certain prices set.

Second, their orders are usually large and therefore stay longer on quoting board (unless they change their orders). This is because, 1) orders with prices off their bid/ask prices are comparably small, and get filled quickly, so those prices show (if there's a chance) on quoting board for a short while, 2) orders with prices equal to their bid/ask prices are usually smaller than their orders, so their orders are usually partially filled, so quoting board still remains showing their prices. This seems like "setting prices", but not because they have special power, rather, because their orders are large enough.

Third, our (retail traaders) orders can be filled at/around mid price, is because our orders get filled with other retail traders' orders, who are trying to buy/sell options with fair price (which is mid price). But again, since our orders are small, and get filled quickly, their prices are not staying long on quoting board.

Fourth, MMs set their bid/ask prices based on some complicated hedging strategies (since their portfolio is large and complicated) that limit their risk and guarantee some profit. Their orders are filled usually when some party (trader or institute) send a large order at or close to their bid/ask prices, since these orders cannot get fully filled around mid-price due to their large sizes.

Please point out if I'm misunderstanding any part.

Again, I'm so happy to learn knowledge so fast on this forum. This made me much happier than get some gains blindly. I'm recommending it to my friends.

 

....another thing that happens from time to time is that market makers with very large orders will first try to "float" that order privately , over the phone, to another party who they regularly do business because they know that they are often interested in some of these large orders.

Both sides know their idea of fair value so it is a place they know they can go to fill a 2000 lot order in one shot easily.

They have relationships for a very long time so they know that it is safe to float the order to certain "comrades".

[blackice 5]

11 hours ago, cuegis said:

....another thing that happens from time to time is that market makers with very large orders will first try to "float" that order privately , over the phone, to another party who they regularly do business because they know that they are often interested in some of these large orders.

Both sides know their idea of fair value so it is a place they know they can go to fill a 2000 lot order in one shot easily.

They have relationships for a very long time so they know that it is safe to float the order to certain "comrades".

Thank you. So firstly I guess what I described (how MMs work and why their bid/ask prices seem like setting price) is kind of correct.

Secondly,  I could imagine MMs must talk behind scene to coordinate things. But how, I'm curious. MMs' bid/ask prices are changing pretty fast too, since the underlying asset price is changing fast. If two of them talked on the phone and agreed on some price, next second they might need another phone call again. Is there some automatic system they use for coordination?