# How to tackle the liquidity problems of option trading



## flyhigher (3 July 2006)

I use options for directional betting for big caps. When my options move to deep ITM or OTM, i often found there are no bids in the market. Even though there are bids, the bid price is way out of theoretical value in favor of market makers. I do not have enough cash to exercise options to deliver the stock to close the positions, so the only thing i can do is to pray for someone coming to the market. Does the liquidity bother veteran traders here? How do you guys solve this problem? 
Thanks in advance


----------



## wayneL (3 July 2006)

flyhigher said:
			
		

> I use options for directional betting for big caps. When my options move to deep ITM or OTM, i often found there are no bids in the market. Even though there are bids, the bid price is way out of theoretical value in favor of market makers. I do not have enough cash to exercise options to deliver the stock to close the positions, so the only thing i can do is to pray for someone coming to the market.




2 questions:

1/ What are you using for theoretical value?

2/ Are the bids less than intrinsic value?



			
				flyhigher said:
			
		

> Does the liquidity bother veteran traders here?




Yes



			
				flyhigher said:
			
		

> How do you guys solve this problem?




My solution is to trade liquid markets (i.e. US )

Cheers


----------



## happytrader (4 July 2006)

Hi Flyhigher

Make sure you choose an option series with open interest of at least a couple of hundred.

Cheers
Happytrader


----------



## flyhigher (4 July 2006)

Hi, waynel. Thanks for your reply.

1/ What are you using for theoretical value?
just like shopping for goods, i want to know fair prices
2/ Are the bids less than intrinsic value?
No, the bids are more than intrinsic value but not much time value for long term options. i always go for Long term ATM options to minimise theata when i do the directional bet.

Trading in us market is a good suggestion, however, i am still in the early stage to find a consistent profitable trading strategy. After i get the hang of it in aus market, i will expand positions to the overseas markets.

Other than trading in the us market, do you have any suggestion to solve the liquidty problem? Right now i am trading warrants more often becasue there are always bids and offers there.

Thanks


----------



## flyhigher (4 July 2006)

Hi, happy trader. i always choose option series with high open interests. 
cheers


----------



## wayneL (4 July 2006)

flyhigher said:
			
		

> Hi, waynel. Thanks for your reply.
> 
> 1/ What are you using for theoretical value?
> just like shopping for goods, i want to know fair prices




Hi,

It's hard to help without knowing specifics.

What model are you using to determine theoretical value? Are you using the ASX site? Hoadley? Some other software?

...and are you sure your inputs are correct?

Cheers


----------



## flyhigher (4 July 2006)

I am using black scholes models. Binomial model will reach the same value if time intervals are frequent enough.ASX are good and i found option calculator of comsec pro trader quite handy.
cheers


----------



## wayneL (4 July 2006)

flyhigher said:
			
		

> I am using black scholes models. Binomial model will reach the same value if time intervals are frequent enough.ASX are good and i found option calculator of comsec pro trader quite handy.
> cheers




OK, without knowing the precise situation, two things could be happening.

1/ You are using an incorrect input in your model

2/ MMs are screwing you. 

Lets presume your friendly neighborhood market maker is an honest chap and just trying to pay his grocery bill for a minute. So lets go with scenario 2/. Bearing in mind deep OTM or ITM options have very little extrinsic value.

If you put up an example, maybe we could get further with this.

Cheers


----------



## cuttlefish (4 July 2006)

flighhigher - depending on how long the time frame on your options is - are you sure you're entering dividends properly in the theoretical price? My own experiecne has shown that this is an easy area to make mistakes.   

In relation to getting a fair price - the arbitrage traders often help to smooth things out in that regard.


----------



## flyhigher (4 July 2006)

I normally use naked long term (at least 2 month) ATM options for my directional bet. I never use use bull or bear spread to finance the trade becasue i am not expereinced enough and i am afraid that i could not unwind the other leg when i want to get out of the postion. Any other strategy other than naked options for directional bet is welcomed!
The point is that there no bids and offers when options become deep ITM or OTM. So i trade more warrants now because there is always liquidity there for my small positions. Fair price become second priority in this situation.
cheers
Do you guys use options more often for arbitrage or portfolio insurance? Do you guys do a lot vega and gamma trading?
cheers


----------



## wayneL (5 July 2006)

flyhigher said:
			
		

> I normally use naked long term (at least 2 month) ATM options for my directional bet. I never use use bull or bear spread to finance the trade becasue i am not expereinced enough and i am afraid that i could not unwind the other leg when i want to get out of the postion. Any other strategy other than naked options for directional bet is welcomed!
> The point is that there no bids and offers when options become deep ITM or OTM. So i trade more warrants now because there is always liquidity there for my small positions. Fair price become second priority in this situation.
> cheers
> Do you guys use options more often for arbitrage or portfolio insurance? Do you guys do a lot vega and gamma trading?
> cheers




I use options for speculation and premium collection. Pure arb plays aren't viable for the retail trader.

Vega and gamma, hmmmmm.... well we trade these anytime we enter an option position. But pure vega and/or gamma plays? Yes, when the planets are all in line these are good plays.


----------



## flyhigher (14 July 2006)

Hi, waynel. My bslxm ( put @7.75 expire augus) is priced .775 at asx website with IV 65% now. but the maket bid and offer spread is .43 and .47. Does it mean that the maket maker think iv will collopase immediately? comsec value the option at .42 with iv 28%. confused about different iv here.
thanks


----------



## wayneL (14 July 2006)

flyhigher said:
			
		

> Hi, waynel. My bslxm ( put @7.75 expire augus) is priced .775 at asx website with IV 65% now. but the maket bid and offer spread is .43 and .47. Does it mean that the maket maker think iv will collopase immediately? comsec value the option at .42 with iv 28%. confused about different iv here.
> thanks




HI FH

I haven't got the ASX price history so I can't see whats happening. I think the ASX values are yesterdays figures? Not sure. 

But yes based on what you've said, thats a class A volatility dump there. Were profit figures released or some other announcement?

Margaret or Mag would have a better idea than me. Guys?

Cheers


----------



## NettAssets (14 July 2006)

flyhigher said:
			
		

> Hi, waynel. My bslxm ( put @7.75 expire augus) is priced .775 at asx website with IV 65% now. but the maket bid and offer spread is .43 and .47. Does it mean that the maket maker think iv will collopase immediately? comsec value the option at .42 with iv 28%. confused about different iv here.
> thanks



Hi Flyhigher

where do you find the volatility quotes on ASX
I had a look but couldn't find them

according to my SWare BSL haven't been anywhere near the 60% mark for ages







When you are looking for a quote do you always just throw a feeler into the market depth for a starter?
The MM's don't need to quote a market until there is a market there, and the other players won't always be on line, I always get a bite within a couple of minutes of  putting a teaser in.
John


----------



## NettAssets (14 July 2006)

Another point is that XM is just a recent option series there is probably a good reason for having a look at the strikes each side and seeing how long they have been open

John


----------



## Magdoran (14 July 2006)

flyhigher said:
			
		

> I use options for directional betting for big caps. When my options move to deep ITM or OTM, i often found there are no bids in the market. Even though there are bids, the bid price is way out of theoretical value in favor of market makers. I do not have enough cash to exercise options to deliver the stock to close the positions, so the only thing i can do is to pray for someone coming to the market. Does the liquidity bother veteran traders here? How do you guys solve this problem?
> Thanks in advance





Hello flyhigher,

Sorry, I missed your post, and just saw it.  Thanks Wayne, this is certainly right up my alley - I trade a lot of illiquid ASX markets under specific conditions, and there is quite an art to it.  You really need good analysis, good software, and knowledge of options “Greeks”.

I’m a bit overrun at the moment, but will post a more comprehensive comment when I can over the weekend.


Regards


Magdoran
P.S. I don’t agree with the orthodoxy that you must trade in options that have open interest, but this is requires a specialised approach Mag


----------



## wayneL (14 July 2006)

Magdoran said:
			
		

> P.S. I don’t agree with the orthodoxy that you must trade in options that have open interest, but this is requires a specialised approach Mag


----------



## flyhigher (18 July 2006)

Finally the website is ok again. i have closed all my BSlxm postion today becasue one big shareholders is increasing holding. Hi, Waynel. when you use theroritacl valuation tools on the ASX website, they have already defaut IV, then get you a theoritical price. As for comsec option valuation tools, they got IV there as well. i dont know where they get this IV from. thanks for you guys' input.
cheers


----------



## NettAssets (18 July 2006)

flyhigher said:
			
		

> . Hi, Waynel. when you use theroritacl valuation tools on the ASX website, they have already defaut IV, then get you a theoritical price. As for comsec option valuation tools, they got IV there as well. i dont know where they get this IV from. thanks for you guys' input.
> cheers




Thanks FH that was my queery on the ASX IV's dont know where they got that 60% from.
Sometimes the ASX prices are a bit hard to work out
My software worked out a theoretical price for STOQ6 tonight of 1.18 and ASX gave 1.31 which made the portfolio look quite shiny. 
Actually I just dropped the projected dividend adjustment for 31st aug out of my calculator and I got the same answer as ASX so I guess they don't allow for dividends until they are announced, but the MM's sure don't let you forget them.
Regards
John


----------



## Magdoran (18 July 2006)

flyhigher said:
			
		

> I use options for directional betting for big caps. When my options move to deep ITM or OTM, i often found there are no bids in the market. Even though there are bids, the bid price is way out of theoretical value in favor of market makers. I do not have enough cash to exercise options to deliver the stock to close the positions, so the only thing i can do is to pray for someone coming to the market. Does the liquidity bother veteran traders here? How do you guys solve this problem?
> Thanks in advance



Hello flyhigher,

Depending on your broker, you should be able to exercise an ITM option, and then buy/sell the requisite shares to balance the trade without actually having the capital to do so.  If your broker won’t do this, fire them and find one who can.  Alternatively, trade in sizes you can exercise.

Ok, if you’re trading the ASX “optionables”, there are two classes of trades – ones with market maker obligations, and ones without designated “flex” options.  Entry and exit strategies include reading the trading of options, and knowing how the market maker works to finesse a good price.  You really need very good T/A, good software and knowledge of options “Greeks” to do this.

You need a good options model adapted for the conditions, and need to project volatility movements fairly accurately – tricks I use include not entering on a break out day, but waiting for either a couple of small range or inside days when the volatility comes off if going long the option (buying not selling), and working out where the spread is, and figuring out if I am likely to get set around the centre of the spread or not based on the price action.

Also, I look to exit positions on strength, being stopped out for profit is not usually effective in less liquid options.  Knowing how stocks counter trend is a key aspect to this, I am essentially projecting a time and price point I think the underlying will trade to, and entering at this point aiming for the underlying to then continue in the direction of the main trend, unless playing a short term counter trend play (or both and reversing positions trading the swings). Hence exiting on strength is a key element, plus trading in partial positions. 

I do this in any time frame, if in the weekly, I buy more time, and the actual entry can range over days.  As you can imagine, this is fairly technical, and there is a lot more to this…

Regards


Magdoran


----------



## NettAssets (18 July 2006)

NettAssets said:
			
		

> Actually I just dropped the projected dividend adjustment for 31st aug out of my calculator and I got the same answer as ASX so I guess they don't allow for dividends until they are announced, but the MM's sure don't let you forget them.
> Regards
> John




Just had a look at the ASX calculator and it gives the same theoretical value as my software but gives a margin price 14c higher ? 
I really need to do some more homework on this.
John


----------



## Magdoran (18 July 2006)

flyhigher said:
			
		

> I am using black scholes models. Binomial model will reach the same value if time intervals are frequent enough.




Really? - not what I've found.  They do equate sometimes, but sometimes they don't - depends what you're doing, and how you trade.  I usually use binomial over B&S...  I also configure the model to suit the market and strategy I'm trading... but horses for courses...


----------



## NettAssets (18 July 2006)

Hi All

Can someone help me out with the difference between the theoretical price and the option value in the ASX model.

John


----------



## wayneL (18 July 2006)

NettAssets said:
			
		

> Hi All
> 
> Can someone help me out with the difference between the theoretical price and the option value in the ASX model.
> 
> John




Guessing.......................

The theoretical price uses Statistical Vol? Rather than actual tradeable values?


----------



## dutchie (18 July 2006)

Not sure but I think that its the last price that option traded for.

Cheers

Dutchie


----------



## Nick Radge (18 July 2006)

> My software worked out a theoretical price for STOQ6 tonight of 1.18 and ASX gave 1.31




One way to determine the positions of the market makers is to see which way they settle an option. Markets makers are given teh right to settle the options series each evening. If you believe your theoretical price is correct and then it settles away from that then you know which way the market makers are skewing. In the example above they are clearly long the STOQ6 or the underlying or they are long vol. Either way they will skew in their favour. 

This gets done around the world regardless of what is traded. I remember we used to have hell batlles with settlement prices back on the SFE floor. Prices would be 1 bid at 2 all day only to settle at 3. Being on the offer at 2 all day and not getting filled, just to see it settle at 3 was a major frustration.


----------



## sails (18 July 2006)

NettAssets said:
			
		

> Hi All
> 
> Can someone help me out with the difference between the theoretical price and the option value in the ASX model.
> 
> John



If you scroll down a bit further on that calculator page of ASX, it gives an explanation of each field.  Below are the two you have questioned:



> *Option Value * - from the ASX database (delayed by a minimum of 20 minutes). This is the last price at which the option traded. Note that where the option series has not traded today, but bids and offers are in the market, this price will be the mid point of the bid and ask. Or if there is no bid and ask prices, it will reflect the theoretical value at yesterday ´s close.
> 
> *Theoretical Price * - the theoretical value of the option calculated using inputs as displayed on this page. Find out more about option models.



If live prices differ from theoretical prices it is usually caused by intra-day fluctuations of IV - supply and demand.  Just my   

Does this help?


----------



## sails (18 July 2006)

Nick Radge said:
			
		

> One way to determine the positions of the market makers is to see which way they settle an option. Markets makers are given teh right to settle the options series each evening. If you believe your theoretical price is correct and then it settles away from that then you know which way the market makers are skewing. In the example above they are clearly long the STOQ6 or the underlying or they are long vol. Either way they will skew in their favour.
> 
> This gets done around the world regardless of what is traded. I remember we used to have hell batlles with settlement prices back on the SFE floor. Prices would be 1 bid at 2 all day only to settle at 3. Being on the offer at 2 all day and not getting filled, just to see it settle at 3 was a major frustration.



Thanks Nick, that is interesting info which raises a couple of questions:
When you say "each evening" does that mean at the close of option trading - or is it a later time?  
Do the ASX then use this settlement price to override their "Option Value" field (as per the ASX definition posted to NettAssets)?

I have also found it is easier to get filled closer to the mid price if there is a tight spread between the bid and ask of the underlying which makes sense so the MM's can hedge and lock in their profit.


----------



## flyhigher (20 July 2006)

hi, Market maker dissappered for OTM WPL PUT OPTION  Aagain.


----------

