Volume

[Victor 5]

Dear Kim,

You have warned us traders on numerous occasions of higher/lower options volume earnings plays. As I start to trade with higher allocation, I would like to ask for your advice as to what allocation is appropriate for given Open Interest in certain trades. What % of Open Interest would you recommend to trade if we take into consideration all of the volume that is being generated by us, the traders of the SteadyOptions strategy?

Is it different for monthly/weekly options?

Will setting my own entry/exit targets and trading independently from SteadyOptions alerts (only using them as reference for my own trades after the fact) widen the universe of tradeable Earnings Plays?

As always, thank you for sharing your expertise and Good Luck!

[Kim 7,475]

Excellent question.

There is no firm answer to that question. Higher allocation is definitely not an issue for high volume stocks like SPY, AAPL, CSCO, GOOG etc. Our last few stocks had less volume and OI. I think it really depends - some stocks will be easier to trade, some will cause issues with fills. While volume and OI will give you a good indication about liquidity, sometimes even with smaller OI you will get decent fills, and vice versa. In general, I would not trade more than 10-15% of OI.

I think you can do few things:

1. Trade less size for less liquid stocks.

2. Set your own entry/exit targets - this is probably the most important.

3. Trade different strikes.

4. Trade different expiration - if I trade weekly, you can go for a monthly and vice versa.

5. In general, I do not recommend to chase, but if you still see good value, sometimes it's okay to go 1-2% higher than my entry. In some cases, you can just set different targets than me and exit before my alert. Over long term, it should level out.

6. Patience is a key. Many times the price will calm down after the initial spike. It might still be slightly higher than my alert, but with some patience, you might pay only 1% more instead of 2-3%.

[Victor 5]

Thank you for the response.

Just to ensure that I have the correct reference point, I would like to present an example.

One can currently see in TOS/Tools/Widget 360, a total Call Open Interest of 6,719,801.

The most calls OI is for Sep '12 145 Call option = 197,466.

The most puts OI is for Sep '12 140 Put option = 339,163.

If for whatever reason I decide that I need a 140/145 September strangle, than theoretically it may be viable to trade 10-15% of the lowest OI out of the ones mentioned above. Therefore, my total position size should not be more than 197,466*(0.15)*2=$59,239.80 (Lowest OI, 15%, multiplied by 2). Is that a safe assumption to make?

Do I need to adjust for individual option prices or will this calculation, for the most part, account for those as long as the position is more or less delta neutral?

[Kim 7,475]

59k is number of contracts, not dollar value. You need then to multiply it by the value of the trade ($215) which will give you around $12.6M.

I assume you are referring to SPY..

[Victor 5]

Yes, I was referring to SPY. Can't believe that I forgot to mention such a key piece of information.

Now it makes more sense, since 59k is the number of contracts, not the dollar value.

BTW Just noticed Mark Wolfinger's new article in his column. All about position sizing. Perfect timing!

Thanks for the clarification, it is very helpful.

[cwelsh 1,497]

You will never* have any problems with liquidity on SPY, AAPL, or the large options -- there's enough market makers that you'll be able to trade. You might have to chase a price, or if there's a suden move get a fill you don't want, but liquidity is simply not a problem. There are firms that literally trade hundreds of thousands of contracts on those instruments.

On the lower liquidity ones -- take notes. Some might only have an OI of 10 contracts, but there is six market makers competiting, and you get a fill at a much better point than the midpoint.

My general rule of thumb is on low OI options, that i have not traded before, I ease into. Yes you pay more commissions the first go around, but you learn about it. Also ALWAYS start near the bid -- you might be suprised and get a fill, and then slowly adjust up to the midpoint, or just over.

Pay attention to how long it takes to get the order filled, how long it sits there, the way the price moves on the spread as soon as you enter the trade.

Also as a general rule, the wider the spread, the less likely you'll be able to easily get in and out (getting out is always harder).

But again, simply because there is low OI, does not mean that it is not a tradeable instrument. The ones you have to watch for are the $10.00 stocks with a $2.00 spread on the ATM options. I wouldn't touch that with a ten foot pole.

But if you have a $10.00 stock with only 2 contracts of OI, but the ATM straddle spread is only 0.05? You might be suprised how liquid it is.

HOWEVER, that said, still ease in....you might get an instant fill at the best possible price, but have a hell of a time getting out. That's why trading logs are so important, you learn about the options you trade -- and the better feel you get for them the better.

[Victor 5]

Chris, thank you for sharing your knowledge and congratulations on your new Column!

I noticed you mentioning a trade log in some of your previous posts, I think it is a great idea and I have been considering implementing that myself.

Some of the concepts of liquidity as it relates to derivatives such as options are still a bit counter-intuitive to me. So I would like to provide my understanding of these concepts for this discussion. Please, correct me if I am wrong.

The supply of equity on any particular stock is constant in the short term and price formation occurs as a result of supply/demand dynamics. As far as I understand, there is supposed to be an unlimited supply of options from the market makers at the 'right price' at any given moment. However, the market makers do not always provide unlimited supply (I guess, they have their reasons, e.g. being able to offset their positions). There is also a catch. The price is not dependent on supply/demand, because it is set, so to speak, independently via underlying, time value and perceived IV. So similar to an economy where prices are controlled by the government, a shortage of these instruments occurs and inefficiencies in the market are created. Hence, the equilibrium price cannot be achieved, because the quantity supplied is less than the quantity demanded at that price level. Under these conditions, the spread between the bid and the ask at that particular quantity level becomes wide. In a case when, for reasons unbeknownst to us, the market makers are unable to provide liquidity, the supply curve does not shift and the spread remains wide.

Based on the reasoning above, it may be logical to conclude that while OI is a good indicator of current liquidity, it cannot be taken on it's own merit, without the consideration of the spread between the bid and the ask as the indicator of the current liquidity and the sufficiency of supply.

I know, I am probably missing something. Your feedback would be greatly appreciated.

Thanks to Chris and Kim for your insights that help me understand the dynamics of the derivatives markets better one step at a time.

A graph, showing a shortage is attached for reference. (Courtesy of Economics @ ITT, http://ittecon.wordpress.com/)

[Victor 5]

Thank you for the response.

Just to ensure that I have the correct reference point, I would like to present an example.

One can currently see in TOS/Tools/Widget 360, a total Call Open Interest of 6,719,801.

The most calls OI is for Sep '12 145 Call option = 197,466.

The most puts OI is for Sep '12 140 Put option = 339,163.

If for whatever reason I decide that I need a 140/145 September strangle, than theoretically it may be viable to trade 10-15% of the lowest OI out of the ones mentioned above. Therefore, my total position size should not be more than 197,466*(0.15)*2=$59,239.80 (Lowest OI, 15%, multiplied by 2). Is that a safe assumption to make?

Do I need to adjust for individual option prices or will this calculation, for the most part, account for those as long as the position is more or less delta neutral?

So aside from my confusion between $ value and # of contracts, I probably should not multiply by 2, because the OI of a strangle pair would be no more than 197,466 and we are multiplying by the total price of the entire strangle.

197,466*0.15*255, which equals about $7.5 mil.

[Marco 221]

Chris, thank you for sharing your knowledge and congratulations on your new Column!

I noticed you mentioning a trade log in some of your previous posts, I think it is a great idea and I have been considering implementing that myself.

Some of the concepts of liquidity as it relates to derivatives such as options are still a bit counter-intuitive to me. So I would like to provide my understanding of these concepts for this discussion. Please, correct me if I am wrong.

The supply of equity on any particular stock is constant in the short term and price formation occurs as a result of supply/demand dynamics. As far as I understand, there is supposed to be an unlimited supply of options from the market makers at the 'right price' at any given moment. However, the market makers do not always provide unlimited supply (I guess, they have their reasons, e.g. being able to offset their positions). There is also a catch. The price is not dependent on supply/demand, because it is set, so to speak, independently via underlying, time value and perceived IV. So similar to an economy where prices are controlled by the government, a shortage of these instruments occurs and inefficiencies in the market are created. Hence, the equilibrium price cannot be achieved, because the quantity supplied is less than the quantity demanded at that price level. Under these conditions, the spread between the bid and the ask at that particular quantity level becomes wide. In a case when, for reasons unbeknownst to us, the market makers are unable to provide liquidity, the supply curve does not shift and the spread remains wide.

Based on the reasoning above, it may be logical to conclude that while OI is a good indicator of current liquidity, it cannot be taken on it's own merit, without the consideration of the spread between the bid and the ask as the indicator of the current liquidity and the sufficiency of supply.

I know, I am probably missing something. Your feedback would be greatly appreciated.

Thanks to Chris and Kim for your insights that help me understand the dynamics of the derivatives markets better one step at a time.

A graph, showing a shortage is attached for reference. (Courtesy of Economics @ ITT, http://ittecon.wordpress.com/)

we're actually a discussion about whether supply and demand affects options prices and MM behaviour here (posts 27-31)

I think option theory that states option prices are independent from supply and demand are just that: THEORY. You can test the PRACTICE yourself if you have a few thousand $ to spare and lift a MM in an illiquid stock in a few 100 contracts and see if/when the price changes. The same will even apply to AAPL or SPY but of course due to much higher supply on these names it will need a lot more to move the option price there. So its just a question of how much will it take to move the price, not will the price move.

[Victor 5]

Marco,

Yes, I remember reading that discussion and even saving that 40 page PDF for a later review. Thanks for pointing out to that discussion.

I agree with your statement that theory is theory. However, I feel like it is necessary to understand the theory behind we do here in order to be able to make correct assumptions in various areas of our analysis.

I also agree with the idea that, in practice, larger volumes can impact pricing, but I think that impact is more indirect with options. Additionally, economic theory and other theories, for that matter, only describe what happens in a perfect world given that certain conditions are true. And in practice there is usually a lot more 'noise' that comes from the human factor as well as from the inherent interrelatedness of a million other factors, or a self-fulfilling prophecy. I just think that this theory helps to see through that 'noise' and make the correct decisions.

It seems that a lot of the discussion on price fluctuation due to volume focuses on market makers. It would be nice to hear about other market participants who do not have the legal obligation to sell according to the options pricing model. Are they statistically significant?

Also, theoretically speaking, if we, as people of this forum, 'gang up' and refuse to pay more than what official (TRADES) alerts indicate, all else being equal, would that, even if it's just in theory, not eliminate the after (TRADES) spikes we've been experiencing recently?