# Trading Option Spreads - which broker is best?



## bingk6 (20 July 2006)

Hi All,

I am new to this forum, so please be gentle !!!

I like to know whether there are any brokers that allow option spreads to be entered ONLINE. At present, I use etrade, who will allow spreads to be entered, but you would need to phone up. Because the trade is entered via the telephone, it is not trackable over the net and the only way you can find out whether it has gone through is to phone the broker up. These days, who has the time to do that !!

Secondly, even when you have managed to get a spread order into the market, I am curious as to how it is going to be filled. The way I see it, there are two options

1) Look for an existing spread order that is already out in the market and try to fulfil it that way, eg if you are trying to buy a butterfly, the broker will try to find somebody that is trying to sell the exact same butterfly and then marry them together. In a small market such as Australia, what are the odds that a butterfly with the same strikes, expiry etc etc matches what you are looking for.

OR

2) The broker dissects your butterfly into the different legs and then tally up the various INDIVIDUAL debits and credits to see if it meets your credit/debit requirements. This way, if you were trying to buy a butterfly, the four individual legs could come from four different traders. 

It would seem to me that option 2) is more likely, as option spreads would probably cease to exist (at least in Australia) if option 1 was reality. However, I suspect that the methodology adopted by different brokers can vary.

I would appreciate any feedback, as I have not used any spreads because of the lack of a suitable broker. I know that etrade will eventually introduce multi-legged option spreads online, but how long will it be ??

Bing


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## spitrader1 (20 July 2006)

*Re: Trading Option Spreads - which broker is best*

bing no theres not...the way the brokers do it is they ring the market makers  for a qoute who then enter spreads into click which then registers on the different screens.


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## wayneL (20 July 2006)

*Re: Trading Option Spreads - which broker is best*

US & European MM's quote on all the vanilla spreads... flies, verticals, etc. but don't know about here.

You can enter any spread you like online in the US as well. I'm sure OptionsXpress allow online spread trades here as well.

Margaret (Sails) will know.

Cheers


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## sails (20 July 2006)

*Re: Trading Option Spreads - which broker is best*



			
				bingk6 said:
			
		

> Hi All,
> 
> I am new to this forum, so please be gentle !!!
> 
> I like to know whether there are any brokers that allow option spreads to be entered ONLINE. At present, I use etrade, who will allow spreads to be entered, but you would need to phone up. Because the trade is entered via the telephone, it is not trackable over the net and the only way you can find out whether it has gone through is to phone the broker up. These days, who has the time to do that !!




Hi Bing, OptionsXpress is the only broker to my knowledge where you can enter a combo (two legs only at this stage) online.  I did hear last week that WebIress may be considering adding the feature.  Also heard that OX may be planning to use Iress as well some time in the future   .  OX also has very reasonable brokerage rates.

However, if you want to place an order for a butterfly and have it filled as a single order, you still have to phone them and you give them the price (net debit or credit) for the combined trade.



> Secondly, even when you have managed to get a spread order into the market, I am curious as to how it is going to be filled. The way I see it, there are two options
> 
> 1) Look for an existing spread order that is already out in the market and try to fulfil it that way, eg if you are trying to buy a butterfly, the broker will try to find somebody that is trying to sell the exact same butterfly and then marry them together. In a small market such as Australia, what are the odds that a butterfly with the same strikes, expiry etc etc matches what you are looking for.
> 
> ...




As I understand it, the market makers take the other side of combination orders and all legs of the trade are executed together.  

For instance, if you are ordering a 10 lot butterfly, the entire quantity of 10 may not be filled at once.  Let's say 6 of the 10 are filled, this means that 6 whole butterflies are filled.  The separate legs are never split up and traded on their own unless you choose to do that yourself.  That would defeat the purpose of putting the trade on as a spread and would open it up to the risk of the market moving unfavourably while you are waiting for the any other legs to be filled.

Hope that helps!

Margaret.


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## bingk6 (20 July 2006)

*Re: Trading Option Spreads - which broker is best*



			
				sails said:
			
		

> The separate legs are never split up and traded on their own unless you choose to do that yourself.  That would defeat the purpose of putting the trade on as a spread and would open it up to the risk of the market moving unfavourably while you are waiting for the any other legs to be filled.
> 
> Hope that helps!
> 
> Margaret.





Hi Margaret,

Many thanks for your detailed reply. What you have said is exactly right. The spread has to be a all or nothing and has to be completed as a single transaction. 

But in addition to that, if you were to individually enter each leg, there could be significant margin requirements which can impact the way you trade. As an example, if I wanted to enter a bull put spread, which involves a short put and a long put. If entered the legs separately, etrade (as an example) would put aside half of my transaction value for the short put leg (eg. 10 contracts with strike of $3.00 implies a transaction value of $30K, off which etrade will reserve (freeze) 15K of my trading funds, just in case the short put is exercised). The long put will just be subjected to the normal ACH margin requirements, which is significantly less than what Etrade will put aside. So entering these 2 legs individually, not only opens my position to unfavourable market trends, but it also significantly impact my ability to trade, with Etrade freezing my funds, that I would otherwise be able to use it for something else. 

Having said that, If I were to contact Etrade over the phone and placed the Bull Put Spread as a single ticket, then they will NOT freeze my funds (15K as in above example) because they would consider it a "fully covered" spread, able to be covered by the normal ACH margin requirements.

Hopefully, trading of multi-legged options spreads via Etrade will not be too far away.

Bing


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## bingk6 (20 July 2006)

*Re: Trading Option Spreads - which broker is best*



			
				sails said:
			
		

> As I understand it, the market makers take the other side of combination orders and all legs of the trade are executed together.
> 
> Margaret.




If we have to deal with MM for all combination orders, surely there is not going to be a bargain. It would akin to buying something at a discount price from Kerry Packer   : It just does not happen.

Under such circumstances, surely taking all the worst cases for each individual leg (ie.paying the asking price for long positions and paying the bid price for short position) should still result in a better deal that what is being offered by the MM. 

Why can't the broker list on their website details of all the option spreads being  offered and/or sought , so that other option traders can buy and sell option spreads just like ordinary shares ??


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## sails (20 July 2006)

*Re: Trading Option Spreads - which broker is best*



			
				bingk6 said:
			
		

> Hi Margaret,
> 
> Many thanks for your detailed reply. What you have said is exactly right. The spread has to be a all or nothing and has to be completed as a single transaction.
> 
> ...



Bing, if you have to order each leg separately, perhaps purchase the long first and then complete the spread with the written option.  There is a lot more safety by purchasing the long first and it should resolve the problem of so much margin.


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## sails (20 July 2006)

*Re: Trading Option Spreads - which broker is best*



			
				bingk6 said:
			
		

> If we have to deal with MM for all combination orders, surely there is not going to be a bargain. It would akin to buying something at a discount price from Kerry Packer   : It just does not happen.
> 
> Under such circumstances, surely taking all the worst cases for each individual leg (ie.paying the asking price for long positions and paying the bid price for short position) should still result in a better deal that what is being offered by the MM.
> 
> Why can't the broker list on their website details of all the option spreads being  offered and/or sought , so that other option traders can buy and sell option spreads just like ordinary shares ??



Hi Bing,

You are right - not easy to get a bargain!

However, the main advantages are:

1.  It eliminates the risk of an adverse market move of trading each option separately and the margin issues you have already pointed out.

2.  In the case of two legged spreads, I have found that the MM's are often more willing to come closer to the mid price than they will if trading each option  individually where they often won't come much above the bid or below the offer.  At times I have found placing a combo order can improve the price by a couple of cents compared to legging it.

I have sometimes seen half my combo orders sitting in the market depth when there is a fair bit of liquidity - so it is possible that they wait for someone else to take that side of it (seems they keep the best price for themselves!).  Apart from that, I don't know exactly how the market makers handle their orders in a practical sense so I'm sorry that I can't be more help.

Margaret.

PS. Magdoran, if you are reading this is there anything else you can add?


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## Magdoran (21 July 2006)

bingk6 said:
			
		

> I like to know whether there are any brokers that allow option spreads to be entered ONLINE.






			
				sails said:
			
		

> Hi Bing, OptionsXpress is the only broker to my knowledge where you can enter a combo (two legs only at this stage) online.  I did hear last week that WebIress may be considering adding the feature.  Also heard that OX may be planning to use Iress as well some time in the future   .  OX also has very reasonable brokerage rates.
> 
> However, if you want to place an order for a butterfly and have it filled as a single order, you still have to phone them and you give them the price (net debit or credit) for the combined trade.





Margaret is spot on here.  OptionsXpress covers spreads, “combo’s” and Straddles for the Australian market, but also covers butterflies and condors as well for the US market.





			
				bingk6 said:
			
		

> Secondly, even when you have managed to get a spread order into the market, I am curious as to how it is going to be filled.







			
				sails said:
			
		

> As I understand it, the market makers take the other side of combination orders and all legs of the trade are executed together.
> 
> For instance, if you are ordering a 10 lot butterfly, the entire quantity of 10 may not be filled at once.  Let's say 6 of the 10 are filled, this means that 6 whole butterflies are filled.  The separate legs are never split up and traded on their own unless you choose to do that yourself.  That would defeat the purpose of putting the trade on as a spread and would open it up to the risk of the market moving unfavourably while you are waiting for the any other legs to be filled.




Once again Margaret is spot on.  The way the system works is that the market makers may allow some discount for a whole spread depending on their disposition on the day, and the way the market is trading.  You can often get set in the middle of the spread depending on the conditions, or better on some occasions in the firing order on the day if there is a lot of action and there is a favourable skew that your order picks up.

You’d be amazed at some of the favorable entries that you can get – my full service broker used to think I was nuts putting in a high credit amount for a spread, or small debit for various positions, and when they transacted he was suitably amused, but after a while got used to me...

What happens is that the broker enters the whole spread with a credit or debit amount, and as each option moves around that makes up part of your leg, there is a bid and ask moving around based on the current bid and ask of each leg.  As the bid and ask spread moves, so does your corresponding bid/ask – 

Example:  you want to place a bull put for BHP when it is trading around $28.80 – you are looking to sell the $29.50 August put (bid 1.71, ask 1.81), and buy the $28.00 August put (bid 0.95, ask 1.05).

The natural price to enter is 0.66 credit by buying at the ask, and selling at the bid. The maximum you can get is 0.76 by selling at the ask, and buying at the bid, but this is unlikely unless you are expecting a pull back sufficient to get set at this amount during the day (possible if you enter the order though and let it transact...).

What might make sense is to go in-between the spread (say at 0.71 or 0.70) if you are anticipating that the stock is about to rise and will not come back to this level within your trading time frame.  What happens then is the market accepts your two orders to buy and sell, and based on the current bid for the selling leg, and the ask for the buying leg your order appears in the market where if either leg sold, the other could be immediately transacted.

So if the bid moved up on the 29.50 selling leg, your buying order for the buying leg at 28.00 put moves up in the bid.  So, if someone went between the spreads, your other order may move close to the centre, and as the options are transacted, all it requires is for the credit limit requirement to be met.

When you get set sometimes, the weirdest of prices can appear, but in the hurly burly of trading, if transacting with you and anyone else in the market fulfils the market makers criteria, you can get a good fill...

A lot depends on your approach, if you think you need to get set immediately, you have to pay up.  If you’re prepared to be patient, you can get a great entry.  I knew a guy once who got ridiculous ratios for bull put spreads consistently, even 4:1 once when there was a big skew – I have no idea how he did it, but somehow in the maelstrom of option transactions, he got set at this level (he was amazing, turned 40K into 100K in one month just trading bull puts).

Anyway, I’ll be out of the country for a few days, but I’ll try to answer any questions when I get back.


Regards


Magdoran


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## spitrader1 (21 July 2006)

bing when you say in ure comment you cant find a bargain you hardly ever will..without giving two much away i have over ten years working for a major investment bank, both trading cash and derivatives......the "bargains" you are looking for rarely exist, and if they do, major investment banks invest miliions of dollars every year to have black boxes and traders who pick them up way before you have even thought about it....not being harsh, just a reality...there is only one real way to trade options i believe in the asx market. You either purchase options as a lottery ticket and from day 1 debit your trading account accepting you have lost that money, or use the options as a hedging tool for your cash portfolio.


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## bingk6 (22 July 2006)

*Re: Trading Option Spreads - which broker is best*



			
				sails said:
			
		

> Bing, if you have to order each leg separately, perhaps purchase the long first and then complete the spread with the written option.  There is a lot more safety by purchasing the long first and it should resolve the problem of so much margin.




Thanks Margaret, I will give it a try to see if this approach does in fact resolve the margin issue. 

On a purely hypothetical case, if what you suggest is correct, what will happens if you try to close down the spread leg by leg. In all likeihood, this may not happen as you will want to shut the spread down in a single transaction (just as you would initiate the spread in a single transaction). However, if you were to shut the long put first, leaving the short put still active, presumably etrade will try to freeze the 15K (as is above example) before it allows the spread to be broken. ie. it will only allow the long put to be shutdown if 15K is available to be frozen (to accomodadte the short put). If the 15K is not available, etrade will not allow the long put to be shut down.

If this were the case, then there would be restictions on the maner in which I can close the spread down. Are my assumptions correct here ??

Bing


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## sails (22 July 2006)

Hi Bing,

On principle, I always trade into the long leg first and out of it last as it is much safer.   After all, the only reason we purchase the long leg (in a credit spread) is to ensure our losses are limited in an otherwise highly leveraged trade, so it makes no sense to leave the short option exposed.  

What if there was a trading halt just after you put the short leg on and before you add the long leg.  Yes, unlikely that it will happen - but even blue chips have their unexpected trading halts where they gapped considerably once the halt was lifted (eg. NAB's trading losses, AMP, BSL, etc).  I believe this is the reason that E-trade will impose hefty margins as they are not prepared to take the risk even for a few seconds.   IMO, the risk of naked sold options should never be underestimated...

I remember a situation sometime ago where RIO had their earnings announcement about 5 minutes after the market closed on expiry day.  I believe there were quite a number of sold call options which the sellers believed were "safe" to expire worthless on the day.  However, the earnings were much better than anticipated and many of the traders who owned those call options decided to exercise - unbeknown to the option sellers at the time.  The next morning, the sellers found that, not only had RIO gapped up extensively, but they were short the shares from being exercised - not a pretty picture.

Take care out there!

Margaret.


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