Think First

Kim · August 28, 2012

One of the problems with trading is the perception that it is an easy business and that almost anyone can prosper. In fact, almost the exact opposite is true. Many can succeed but the commonly used estimate is that 95% of people who try to become successful investor/traders fail.

I am sure that every Options for Rookies member already understands that trading is not ‘free money’ and that some effort is required to master the information and develop the required skills. For some, it does prove to be fairly easy and trading comes naturally. Others take their time and absorb the information at a rate that works for them.

For the vast majority, it requires understanding what you are doing and paying attention to the details. I recently corresponded with someone who did not take the time to pay attention to all details. I know he understands the principle, but for some reason, one important step was overlooked in the order-entry process.

This whole concept is worth further discussion.

I can’t buy back my short SPX Sep 1295/1305 put spread.

I have a $.20 bid in, and the mid-point is $.10.

There are several ways to go about entering orders. One is to look at the bid/ask midpoint and try to get the trade filled at a price near that mid-point. This is a perfectly normal and acceptable way to think.

However, we must pay attention to the details and use some common sense. And that means taking the extra moments to look at the bid/ask quotes to see if there is something valuable in them.

Let’s take a closer look at the spread under discussion. With the short option being more than 100 points OTM, it seems like a good idea to cover by paying a very low price, and eliminate the risk of a market downturn. Especially when there is so little left to gain by holding the position.

The efficient method for determining the real market for the spread, is to set up that spread on your broker’s trading platform and look at the bid/ask quote. I’m sure your broker has a way for you to see the price of a put or call spread, as well as for the entire iron condor.

Scenario 1

The bid is $0.05 and the ask price is $0.30

This makes it reasonable to bid a low price with some realistic chance of being filled. In this scenario, a 20-cent bid makes sense.

Scenario 2

The bid is zero and the ask is $0.50

We do not know the true market here. There is probably a bid above zero, but it is not being published. The true midpoint may be $0.30. There is not much chance of getting filled on a 20-cent bid, but I always enter that bid for two reasons:

1) If the market moves, someone may decide to sell it.

2) If there is some trading volume in these low-priced options, it is very possible that some individual investor will enter a bid (for the option I want to sell) or offer (for the option I want to buy) that temporarily sets up the spread with an offer that matches my bid. If that happens, my broker’s computer snaps up both sides and fills my order. This may not be likely but it is possible.

Scenario 3

The bid is -$1.50

The ask is +$1.70

The midpoint is $0.10

It is a virtual impossibility to buy this spread at $0.20.

When the bid is less than zero, the midpoint is meaningless.

The true bid is probably 40 or 50 cents, even though it is not showing. But more importantly, if the offer is $1.70, no one is going to sell at twenty cents.

This type of wide market occurs often enough that we must be aware. It is important to look at a market like this and recognize that the true midpoint is at least 85 cents (half of the ask price), and probably higher.

Consider the other side. If you wanted to sell this spread, would you look at that 10 cent midpoint and offer it at 10 cents? Of course you wouldn’t. Well, when buying we have to look at the complete market.

I understand how trivial this topic is. But the bigger picture requires that we know what we are doing. If we go to rote actions such as automatically entering the same order every week, or always choosing one strategy without knowing that this is really the most appropriate for you, or always looking at the midpoint and assuming that is the best market valuation, you are going to get into trouble. Traders must be alert. Money is always on the line.

We cannot always make the decision that tuns out to be a winner, but we can always make a good decision – a decision that gives us a good chance to earn money. Paying attention to details is part of what is necessary to make good decisions.

There was no harm done in entering that 10-cent bid. But, this trader was frustrated – and that is never good. There was no need for mental anguish.

Mark Wolfinger

https://www.mdwoptio...mium/home-page/