{"id":193137,"date":"2023-07-07T12:00:00","date_gmt":"2023-07-07T16:00:00","guid":{"rendered":"https:\/\/ibkrcampus.com\/?p=193137"},"modified":"2023-07-07T12:44:45","modified_gmt":"2023-07-07T16:44:45","slug":"the-posted-bid-ask-is-negotiable-2","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/traders-insight\/securities\/options\/the-posted-bid-ask-is-negotiable-2\/","title":{"rendered":"The Posted Bid\/Ask is Negotiable"},"content":{"rendered":"\n

I had the privilege of attending the Canadian Annual Derivative Conference in Montr\u00e9al recently.  Although it\u2019s an event I\u2019ve been attending for at least 20 years, this was the first time my perspective was that of a former options market maker rather than an active one.  As usual, I learned about unfamiliar aspects of the market from a wide range of speakers (and of course, enjoyed the cocktail party),<\/p>\n\n\n\n

The important thing to keep in mind is the concept of \u201cfair value.\u201d  When a market maker posts a two-sided market, you can assume that his fair value is the midpoint of those quotes.  Market makers are in the business of buying below their fair value and selling above it.  They are posting the ideal price at which they want to trade that particular contract at that moment, but they are often willing to accept a smaller profit above or below their fair value.  That is price improvement.  Thomas Peterffy explained the process in detail in a podcast we taped<\/a> about a year ago (the full edited transcript is available here<\/a>):<\/p>\n\n\n\n

[A market maker] makes a bid and offer for each option and submits them to the exchange as limit orders. He hopes that he will buy and sell a lot of options at those prices. As the stock prices move around, he moves his market or quote with them based on the option formula he is using. This is of course all done by computers, as millions of auction prices are moving around all day long and the response time for any event must be within milliseconds or microseconds<\/em>.<\/p>\n\n\n\n

When that market maker gets an opportunity to buy an option without pushing the price \u2026 higher at the exchange, that is a huge benefit to him that he is willing to pay for.<\/em><\/p>\n\n\n\n

It is quite common for our customers to receive prices that are better than those posted on the national best bid\/offer (NBBO).  It is not always the case, of course.  For example, if a stock is racing higher, call sellers don\u2019t need to improve their offers.  Also, if a spread is a penny wide, there isn\u2019t much room for improvement.<\/p>\n\n\n\n

As Peterffy noted, a market maker is posting a multitude of prices at any given time.  Consider the number of contracts that are listed on the most popular options, then multiply them by the number of stocks or ETF that the market maker is responsible for.  It is impractical, especially in a fast-moving market, to post one\u2019s absolute best price for every contract.  Instead, they often utilize a slightly wider spread, then respond to bids and offers as they come in.<\/p>\n\n\n\n

In the specific case of Canada, listed options trade only on the Montr\u00e9al Exchange, where there are a few active market makers.  Somewhat uniquely, large orders (usually 250 contracts or more) do not need to be exposed to the market for price improvement.  These are so-called \u201czero-second crosses.\u201d The theory is that sophisticated institutions, who trade \u201cupstairs\u201d, can decide for themselves whether they are receiving fair prices as long as they respect the posted markets at the time.<\/p>\n\n\n\n

There was some logic to this idea when crosses needed to be exposed by phone to the market.  The process was slow \u2013 it could take several minutes \u2013 and thus rife with information leakage.  But zero-second crosses bifurcated the market between small and large investors.  It then became archaic in its own right once the exchange developed the capability for complex orders to be exposed for mere fractions of a second.  However, since the process suits the big banks \u2013 many of whom are not active market makers \u2013 and their customers haven\u2019t advocated for change, the rule persists.<\/p>\n\n\n\n

Under that framework, an institution can negotiate with a bank\u2019s trading desk who uses the posted market as a guide.  If it is a relatively illiquid contract, the spread might be relatively wide, allowing the dealer to improve over the posted price.  Even so, the bifurcated market means that market makers are disincentivized from leaving too much size on the book at tight spreads, since they risk being run over by large orders on which they can\u2019t really participate.<\/p>\n\n\n\n

As a result, that leaves plenty of opportunity for small traders to do their own price improvement.  Remember, market makers are almost always willing to trade any price that offers them a reasonable profit around their fair value.  Let\u2019s say a random option is $1.10-$1.30.  That\u2019s a relatively wide spread, but not truly uncommon.  It is reasonable to assume that the market makers agree that the fair value is thus around the $1.20 midpoint.  Don\u2019t you think that one of them would be willing to sell to you at $1.25?<\/p>\n\n\n\n

There is an easy way to find out \u2013 bid $1.25.  Market makers\u2019 software is generally programmed to hit that bid quickly.  If they all think it\u2019s worth $1.20, there is a real incentive to be the first to hit a $1.25 bid.  Maybe not, but maybe they\u2019ll hit a $1.26 bid, and so on.<\/p>\n\n\n\n

I\u2019ve discussed this in several forums with small investors, and there is a common misperception that the market makers will move their prices rather than trade with them.  This cannot be further from the truth.  Market makers only make money when they trade and are definitively not in the business to avoid trading with small orders.  That is their bread and butter.  Sure, if the stock in question is moving, the $1.25 bid might no longer be appealing.  But more often than not, in a stable stock with options that have a relatively wide spread, price improvement is not that hard to achieve.<\/p>\n\n\n\n

I\u2019d like to think that this should have an element of common sense to it.  It fits so perfectly with my experience as a market maker that it is perfectly logical to me.  Small investors who trade options should always be seeking the price improvement that is readily available to them, regardless of marketplace.  It\u2019s there for the taking.<\/p>\n\n\n\n

—<\/p>\n\n\n\n

Originally Posted June 30, 2023 – The Posted Bid\/Ask is Negotiable<\/a><\/p>\n\n\n\n

The author is a senior officer of an affiliate of Interactive Brokers Canada Inc. (IBC), an approved participant of the Bourse de Montr\u00e9al Inc. (MX) and a clearing member of the Canadian Derivatives Clearing Corporation (CDCC). <\/em>Nothing in this article should be considered an investment or trading recommendation by IBC or any of its affiliates<\/em><\/strong>. Trading in options is highly speculative in nature and involves a high degree of risk. Before trading options listed on the MX and issued by the CDCC, one should read and fully understand the current CDCC disclosure document entitled \u201cThe Characteristics and Risks of Listed Canadian Options.\u201d <\/em><\/p>\n\n\n\n

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.<\/p>\n","protected":false},"excerpt":{"rendered":"

An important thing to keep in mind is the concept of ‘fair value.’ When a market maker posts a two-sided market, you can assume that his fair value is the midpoint of those quotes.<\/p>\n","protected":false},"author":4,"featured_media":192158,"comment_status":"open","ping_status":"closed","sticky":true,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[6,19,8,9,26,3],"tags":[14891,1926],"contributors-categories":[13617],"class_list":{"0":"post-193137","1":"post","2":"type-post","3":"status-publish","4":"format-standard","5":"has-post-thumbnail","7":"category-north-america","8":"category-options","9":"category-region","10":"category-securities","11":"category-text-articles","12":"category-traders-insight","13":"tag-bid-ask-spread","14":"tag-options","15":"contributors-categories-montreal-exchange-option-matters"},"pp_statuses_selecting_workflow":false,"pp_workflow_action":"current","pp_status_selection":"publish","acf":[],"yoast_head":"\nThe Posted Bid\/Ask is Negotiable | Traders' Insight<\/title>\n<meta name=\"description\" content=\"The important thing to keep in mind is the concept of 'fair value.' 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