I'm a futures trader, but am getting interested in trading option spreads. But the bid-ask differentials are huge! For instance, up to 20 percent of the cost of the combo spread price. How do you guys deal with that? Are there some tricks to learn? Thanks
What underlying are you talking about? Some stocks and indices have much better option spreads than others. The simple rule when trading options applies to large bid/ask spreads as well: don't trade options unless you know a lot about them. If you understand options and have a good idea of current theoretical value of the spread you want to trade you can put your order out at a reasonable price and get filled. This one time (at band camp, j.k.) I received a quote $1 bid at $2 from the floor on a large SPX spread, which seems ridiculous but I knew it was worth about 1.55 so I put in an order to sell it at 1.40 and got filled. In order to trade options you need to understand them, how to properly value them, and know your enemy (the market makers). All that said, you're right, option bid/ask spreads generally suck so you can't effectively "trade" them.
You can always try for a price inside the bid-ask spread. I was trying to sell an option the other day that was .40x4.40, but when I put in an offer for 3.40, the bid jumped to 3.00. I eventually got filled at 3.20.
always trade at mid spread, avoid multi leg strategies and less liquid options. in the end, overcoming a 20% b/a spread on the long run is like paying 20% of your net transaction balance to someone else and that's a lot of negative burden on your side, especially after you've made several thousand trades.
I thought that SPY would be a pretty liquid underlying. Are there stocks whose options are even more liquid than SPY? Also, is the theoretical price of the spread calculated simply as the sum of the current bids for the long legs minus the sum of the current asks for the short legs?
You're kidding right? If you don't understand, in detail, how theoretical price is calculated then you should not trade options. Not now, not ever. You will just loss all your money eventually.
OK, sorry, the second part of that question was pretty lame. I do get the idea that the theoretical price can be calculated... and is not determined by the bid or ask -- thanks for reminding me What about the first half of the question, though -- liquidity?
Well since you can't seem to see that I am trying to keep you from throwing money away, I will say that if you just want tight bid/ask then try the QQQQ or NDX. SPY is liquid and relatively tight bid/ask also, but when you multiply it by 10 to compare to the SPX you will soon see there are no good spreads with options. $1 bid at $1.01 is exactly like trading a stock that is $100 bid at $101. Would you trade AAPL or IBM if it were a dollar wide? So the huge bid/ask compared to stocks and futures and the added component that you don't seem to understand theoretical value, theta, gamma, delta, etc. should make you think twice.
Hey, I'm really appreciating your advice! Really! So I went to the CBOE site and listened to the webcast from Dan Sheridan. He likes the "double-diamond." That seems like an interesting strategy -- makes money if the underylings don't change very much. For that reason, I'd prefer SPY over QQQQ i would say -- I believe SPY is less volatile. But probably there are other stable stocks to use -- he suggests IBM, BK, and so forth. I'm sure I'll find this out, but I was thinking maybe they would be more liquid. Thanks again for your helpful advice.