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Reading the Bid / Ask Spread
Chris Figy
Have you ever placed an order where you received an immediate fill and then thought to yourself that you could have done better? Maybe you could have bid twenty cents less and still received a fill. How about sending an order that you think should get filled right away, but after waiting fifteen minutes or so, you start thinking to yourself: “These floor guys are trying to rip me off.” Well, I’m going to explain how you can read the bid ask spread to help you place efficient orders. This will also give you a little more comfort knowing that you’re placing a good order. Efficient and effective placing of limits is a must if you plan to successfully trade. After all, if we can save on each and every trade, these savings can add up to a sizable reward by years end. Three Market Types We start by classifying the bid ask spread into one of three different categories. This analysis helps us to place better orders. - The Screen Driven Market: This is the most common quote. In the absence of any customer orders, what you see is the specialist’s “Driven Market.” The Driven Market is a bid and ask that is driven by a machine around a fair value. The exchange has rules as to how wide the specialist is allowed to set the bid ask spread on an option. Examples of what determines this width are the price level of the option, the time until expiration, and current market conditions. The widths are generally fixed even amounts. For example: All options over fifteen dollars are allowed to have a bid ask spread of two dollars; options between fifteen and five are a dollar fifty wide; and options under five have a dollar wide spread. This is the widest quote that we can expect to see when looking at the bid ask spread.
Figure 1: Dollar Wide Screen Driven Market 
- The One Sided Market: This spread is where a customer’s order is being represented on one side of the bid ask spread. The customer’s order is better than the crowd and has created a lopsided spread. The other side of the market is the screen driven market listed above. Generally, we can spot this market easily once the market moves a bit and then all the bid and ask prices shift. When one price will not move with the rest, this is a sure sign that this is a customer order.
For example, in Figure 2, we might see all the bids and offers increase by a dime except for the 1450 call offer. If so, this is a sure sign that the forty-one offer is another customer order. We then look to the ask size to see if it also looks like a customer order. Sure enough in this example, there is only one contract offered at 41.00. All the other bid and offer sizes are showing ten contracts. The ten contracts are representing the specialist size on all markets and confirm these spreads are a screen driven market. Figure 2: One Sided 1450 Call Market 
- The Two Sided Market: This is a market where there are customer orders on both sides of the market or there is a customer order on one side and the crowd’s best bid or offer is being displayed on the other side. This is sometimes the best market quote, as you might be able to trade this option for fair value or better. This market is often only a dime or two wide. In Figure 3 we have a two sided tight market on the 1470 calls. The 1470 calls have a forty cent wide market verse the 1465 calls with a four dollar wide market. (Quite a difference!)
Figure 3: Two-Sided 1470 Call Market 
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Pricing Orders Now that we have classified the bid ask spread into one of three categories, we will determine the fair value of an option for each category to place an appropriate order. You will have to give some amount off of fair value to the market maker to get your order filled. You might offer below fair value by twenty cents and bid above fair value by twenty cents. The examples below will assume bidding over and offering under the fair value by twenty cents will result in a fill. There are finer tactics of “going for value”, i.e. placing a limit order at fair value and waiting for someone who might be willing to trade for value too. In this approach, you would then “cave-in” a dime or nickel at a time until your order gets filled. Below, we will attempt for a faster fill by giving away twenty cents to the market maker off the fair price right out of the gate. Now that we know how to classify the bid ask spread into one of the three types, we can now discuss finding fair value and place our order for each type of market. - The Driven Market - These quotes are created with equal distances above and below the specialist’s fair value. The specialist or market maker will trade around the fair value, sell options over fair value and buy under fair value. Since these quotes are disseminated by a computer and equally spaced around the fair value, we can determine the fair value as the half way or middle point of the quote. If you place orders twenty cents off fair value in the market maker’s favor from the middle point, you should get filled. This “edge” or twenty cents to the market maker will vary across markets. A nickel might work in one market and a dime in another. In fast market conditions you may have to give away forty cents for a fill. It will vary depending on conditions and underlying markets.
- The One Sided Market - This market is one we don’t want to just “middle”. If we look at the 1450 call market in Figure 2, and decided to middle the market to determine a price we might trade at, we will have made a mistake. The middle of the bid and ask is 39.70. After seeing the prices of all the other options change due to underlying movement, and we noticed that the 41.00 offer on the 1450 calls didn’t move, we will assume this is a customer’s order. Knowing the markets are four dollars wide, we can add two dollars to the 1450 call bid to get fair value. This will place fair value for the call at 40.40, and this is the value we should use to determine where to place our order. If we instead just calculated the mid-point and sent an order to sell the 1450 call at 39.50 (twenty cents lower than the mid-price), we would get a fill. But this fill wouldn’t be a good one, as we could have sent a price of 40.20 and also received a fill. By identifying the correct market, we could have saved seventy dollars per one lot traded.
Likewise, if we sent an order to buy the 1450 call at 39.90, our order would just sit there. Having determined that 40.40 is fair value, this bid of 39.90 is not going to get filled by a market maker as he would pay that price too. - The Two Sided Tight Market – For this market, we will use OptionVue’s theoretical values. We determined in Figure 3 above that the 1470 call had a two sided tight market. How can we determine the fair value? We will look to a strike right next to this strike for some help. Looking at the 1465 calls, we know this is a driven market so we can just middle the 1465 bid and ask. The fair market value of the 1465 calls is 29.70. Now we compare this 29.70 fair market price to OptionVue’s theoretical price at 29.34. The theoretical price is .36 under the current fair value. We will assume that this same difference exist one strike up at the 1470 strike. Adding the .36 to our 1470 theoretical price we now have a fair market price of 26.52. The current bid is 26.60. I would guess that this is a customer order and he is currently willing to pay .08 cents over current fair market value. This order will not last long. Once the underlying moves and the market markers see this option priced twenty cents over the fair value, they will take it out. If we were looking to sell this option, this would be a great price as it is .08 above current fair value and .44 over OptionVue’s theoretical price.
In conclusion, this method won’t guarantee you get the best fill all the time, but should improve your chances. It is a way to help one determine where to place orders that result in a fill close to the best price. It may also help explain why some orders don’t get filled.
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