Playing the Bid-Ask Spread When Selling Covered Call Options

An integral aspect of our options trade executions is to sell at the “bid” and buy at the “ask”. Many times we can “negotiate” the bid to a higher price or the ask to a lower price. Would you like to earn $50 in 50 seconds? Why not learn how to play the bid-ask spread?

Blue Collar Investors throughout the world are always looking for ways to generate additional profits into our portfolios. This includes the use of some of the more esoteric maneuvers that may produce small returns of $40, $50 or more. One of the main philosophical approaches to Blue Collar Investing is that by generating small but consistent, low risk returns and then compounding those profits, we can become financially independent.

In my previous books and DVDs, the following phrase appears on numerous occasions:

Sell at the “bid”, the lower price; buy at the “ask”, the higher price. This references the price lists found in the options chains. Before we discuss some common sense applications to maximizing profits by playing the bid-ask spread, let’s review some definitions (stay awake now, this can make you some cash!).

Definitions as they apply to options:

BID: An offer made by an investor, a dealer or a trader to buy an option. It will usually stipulate the price the buyer is willing to purchase the option and the quantity to be purchased. As covered call writers, we sell at the “bid”.

ASK: The price a seller is willing to accept for an option, also called the offer price. The “ask” will always be higher than the bid.

BID/ASK SPREAD: The difference in price between the highest price that a buyer is willing to pay for the option and the lowest price a seller is willing to sell it. If the bid is $2.80 and the “ask” is $3.00, then the bid-ask spread is $ 0.20.

Theoretical Value: The hypothetical value of an option as calculated by a mathematical model such as the Black-Scholes Option Pricing Model.

Black-Scholes Option Pricing Model: A model used to calculate the value of an option, by factoring in stock price, strike price and expiration date, risk-free return, and the standard deviation of the stock’s return.

How the bid-ask spread is set:

There may be several bid prices and several ask prices at any point in time. However, only the highest bid and lowest ask are used to calculate the spread. These are the figures you see when accessing the options chains. Utilizing an estimate of the volatility of the underlying stock, a theoretical option value is calculated using an option pricing model, such as the Black-Scholes model. A market maker will then set the bid below this theoretical value and the “ask” above this theoretical price. This is the spread and is determined mainly by liquidity. For example, the highly liquid ETF QQQ has bid/ask spreads as low as $ 0.01. This is one of the reasons I require all stocks owned in our portfolios and on our watch list trade at least 250,000 shares per day and options to have an open interest of 100 contracts and/or a bid-ask spread of $0.30 or less. Market makers derive their profit from bid/ask spreads. The greater the spread, the more money they make. Playing the spread will decrease their profits and increase ours.

Market order vs. limit order:

If you use a market order when executing a trade, you will sell at the published bid price and buy at the published ask price (this is called “lifting” the offer or “hitting” the bid). This may be okay for the purchase and sale of stocks where the spread is tight (small), but for options, which have a wider bid/ask spread, a limit order is more appropriate and beneficial.

The Show or Fill Rule:

This is also called the Limit Order Display Rule or technically the Exchange Act Rule 11Ac1-4. This regulation requires the market makers to show or publish any order that improves the current bid or ask prices unless it is filled. Any order between the current bid-ask spread will improve the market.

Practical Application:

Most exchanges have a policy in place that requires market makers to fill AT LEAST 10 contracts at the quoted price. For many equities and ETFs the number of contracts required is a lot more and varies from security to security. These players want to buy securities at the lowest price (bid) and sell at the highest price (ask or offer). Now it’s time for Blue Collar Investors all over the world to become annoying and take out our slingshots in much the same way that David approached Goliath. As long as the bid-ask spread isn’t too tight or close together, we place our order between the two quoted prices. If the market maker (MM) does not fill the order, he will be required to publish it and then be obligated to fill at least 10 contracts, perhaps more, at that price. Since most of us are selling small numbers of contracts, let’s say up to 5 per stock, it is in the best interest of our friends on the other side to just fill our orders and settle for a lower amount on 5 contracts rather than be obligated for twice that amount and for many more traders. We got them right between the eyes….I mean between the bid-ask spread.

Example:

In this hypothetical the bid is $2.50 and the “ask” is $3.00. That’s a spread we can work with. As covered call writers, we sell at the bid or in this case, $2.50 per share or $250 per contract. That’s the price at which the MM wants to buy our options. Instead our offer will be $2.65. That betters the current published offer of $3.00. Therefore, our friend on the other side has a dilemma: Do I fill these 5 contracts @ $2.65 or publish the new, improved offer and be responsible to fill 10 or more as required by the Show or Fill Rule? In most cases, we will get our $0.15 and the MM will get rid of us. This little maneuver will pay for our commissions and buy us lunch at Wendy’s. $75 becomes hundreds, becomes thousands, and becomes tens of thousands and so on. The market makers? They’re gazillionaires anyway…they’ll be alright.

****DO NOT CHECK THE ALL OR NONE (AON) BOX ON YOUR TRADE ORDER FORM:

All or None Box

For most of us checking this box is redundant, not necessary because the MM is required to fill at least 10 contracts. If this box IS checked the MM is no longer required to publish our offer and we will lose our leverage when playing the bid-ask spread.

A market order should always get filled as you are buying a said number of shares “at market” so you will hit offers until you have a fill. Limit orders will only fill at your specified limit price or better. If you don’t want partial fills and you are trading a large number of contracts you can use the all or none order. They will fill the whole order or nothing. However, this will be counterproductive when playing the bid-ask spread.

Conclusion:

To take advantage of the show or fill rule we must:

• Improve the market (bid-ask spread)
• Sell 10 contracts or less
• Not check the all or none box on the trade execution form

Blue Collar Investors have certain tools available that will level the playing field with the MMs. Taking advantage of the Show or Fill Rule is an important one especially when selling a small number of contracts. Although each successful trade will generate a small amount of cash, over time this will add up to significant dollars that will help to secure our financial future. Unlike David, though, we are not looking to injure our adversaries, just annoy them.

June 12th: I will be the keynote speaker for the New York City Private Investors Group at the ING Direct Cafe:

To sign up (seating is limited):

http://www.meetup.com/NYCPrivateInvestors/events/49668332/?a=ea1_grp&rv=ea1&_af_eid=49668332&_af=event

Time: 6PM to 7:30 PM

Admission is FREE and non-members are welcome.

Free resources and glossary:

In an effort to provide our members with the most thorough and informative covered call website available, we have recently added two new features to the general site:

1- Covered Call Glossary

2- Free resources including the Basic Ellman Calculator

Look for the links on the top bar of all pages of our site. Although the Blue Collar team is quite proud of our top-rated site, we will continue to listen to your valuable feedback and make enhancements that will take our site to even higher levels.

Market tone:

This was a light week for economic reports but included some encouraging news from the housing market:

• New home sales increased by 3.3% in April and up 9.9% compared to April, 2011
• Existing home sales rose by 3.4% in April following two straight months of declines and up 10% from April, 2011
• Single-family home sales increased by 3.0% and condominium and co-op sales rose by 6.0%
• The national median existing home sales price rose to $177,400 in April, up 3.1% from March and 10.1% from April, 2011
• New orders for durable goods increased by 0.2% in April, slightly below expectations but an increase from the 3.7% decline in March

For the week, the S&P 500 rose by 1.7% for a year-to-date return of 5.70%, including dividends.

The VIX has calmed this past week to a level of 21 but has been erratic at best the past 3 months as shown in the chart below:

VIX- A 3-month chart

Note the following:

• The red arrows highlight the rapid spikes in the VIX during the past 3 months
• The green arrows show the subsequent declines in the VIX
• The yellow field shows a calm and stable VIX, an ideal scenario for the conservative strategy of covered call writing

Summary:

IBD: Market in correction

BCI: Cautiously bullish as the recent housing reports are huge for a recovering economy. This is more than likely a reason for continued improvement in consumer sentiment (79.3, the highest level since October, 2007).  However, I continue to favor in-the-money strikes to hedge the recent market volatility.

Happy holidays to one and all,

Alan ([email protected])

www.thebluecollarinvestor.com