Many options traders have reason to remember the morning of October 27. Before the markets opened, those who belong to trading groups were probably sending many emails or Skype messages back and forth, determining what the best tactic would be to adjust their in-trouble trades or manage their profitable ones. From what I could see, traders held far more of the in-trouble type than profitable ones, but I hope some subscribers, at least, profited from the big move up.
However, I know one trader who had a 10 percent profit against the maximum margin but didn't collect that profit immediately and saw it quickly evaporate. Already, before the markets opened, I was thinking of the advice of Jeff Augen in The Option Trader's Workbook. Augen advised that if there was a huge move at the open, such as the near two-standard-deviation move in the first few minutes of the trading day on October 27, the profitable trader should take profit immediately. That advice was predicated in part on the supposition that such huge moves at the open were rare and likely to be reversed.
I bought Augen's book several years ago. We can argue against both suppositions these days. Markets seem to gap much more often than they did in the past. Those gaps are sometimes reversed but sometimes not, with moves that create "the most in history" and "the most in x number of years" headlines. Does Augen's advice still prove sound?
Generally, yes. What we can't argue with is another point Augen knows and experienced options traders have observed. Option prices are inflated at the open and likely to be even more inflated with such huge gaps. The inflation is partly due to supply-and-demand. The inflation is also due to uncertainty that is reflected in higher implied volatilities. If your trade is profitable at the open, then it's profitable at least in part due to those higher implied volatilities. If the move settles down in magnitude, even if it continues in the direction of the gap, some of those inflated implied volatilities are going to come in. Your biggest profit may be at the open, no matter how much further prices go in your favored direction later in the day. Sometimes, when potentially market-moving economic releases or other developments are expected within thirty minutes of the open, the implied volatilities remain inflated until the release and then quickly lower at that point. Of course, other times will exist when Augen's advice would be wrong, and you'll be leaving money on the table. Unless you have experience in gauging how the implied volatilities are likely to change during the day and you also happen to have advance knowledge of the outcome of economic releases, rumors about to be floated that might impact these emotion-driven markets and other such matters, you have no way of knowing in advance.
Let's look at the converse of this. What if a trade is going to be in trouble with a huge whoosh up or down at the open? Likely on the morning of October 27, that would have happened to those in bearish trades. Imagine that a trader had a bearish trade and wanted to protect it, perhaps by buying calls at the open, planning to stabilize the position until it could be determined what would happen next. While exceptions exist, that may not be a great idea, either, due to the same inflation in early trading.
For example, before the open that day, I had determined that I would use that morning's actions to make some live observations for this article. I began pricing a NOV SPX 1310 call as soon as the market opened and I could get quotes. The first mid-price or mark I determined, moments after the open was 9.40, although TOS's charts of the option price show that the high price in that first 30 minutes was about 9.85. Someone likely bought a really inflated option, if someone bought it for that price! By the time the 10:00 economic releases rolled around, that option's mark had dropped to a low of about 7.80. In this case, it might have been a good idea to buy at that time, because the option did increase in value throughout the rest of the day, really zooming up in the last few minutes of trading as disappointed bears had to do some buying to cover and hopeful bulls maybe did some, too.
However, when markets go sideways to slightly up after a big gap, a call's value can decline throughout the day. The prices kept escalating in this instance because important levels such as the SPX's 200-sma were being tested and then exceeded, and volatility and volume were picking up as a result. Traders must make up their own minds. I was going to buy in of some spreads I needed to roll that morning, and I elected to sit out the first 40 minutes or so, letting the initial overpricing subside and then do the buying.
The spread I was buying to cover was a 1310/1330 spread. As you can imagine, prices were jumping all over the place. In out-of-the-money spreads such as these, the volume may be somewhat thin, and someone out in cyberspace may send in a small order inside the bid or the ask that doesn't get immediately filled. As I've mentioned in other articles, such activities distort the mid-price or mark, so that it can be difficult to determine what the true price of the spread is. Those who complain that they can't get filled anywhere near the mid or the mark on the SPX and OEX and have to pay way too much or get way too little credit are often looking at an erroneous mid-price or mark. Let's look at a couple of examples of that spread, taken from TOS's "Market Depth" at a couple of times during the day to see some live examples.
TOS Market Depth Screen at 10:04 am CST with SPX at 1270.19:
The vertical's bid and ask prices are shown in the first two lines. Here we see the spread itself has a mid-price or mark of (3.20 + 6.30)/2 = 4.75. Is this the true mark for that spread? How would we know?
The bid and ask for each component of that spread are below the vertical's bid and ask. In addition, bid size (BS) and ask side (AS) can be found. As we scan those sizes for the CBOE, we see 100 for bid size for both options and, for ask sizes, 204. These typical large numbers indicate that these are probably the market makers' numbers. The marks for each of these strikes that are components of the spread should be fairly accurate. Although in a sharply rising market, one might not be able to get that spread filled for exactly the mark or maybe wouldn't be able to get a complex order filled at all, at least the trader who knows the true mark has more information about where to place the order.
A few minute later, the situation was different.
TOS Market Depth Screen at 10:12 am CST with SPX at 1270.82:
The mark for the spread is now (3.20 + 5.40)/2 = 4.30. Is this the true mark? We see that bid and ask and bid size and ask size for the 1330 option remain the same as they were a few minutes earlier. Bid price remains the same on the 1310, too, but the bid size has changed, so we know there's likely a 75 contract order(s) at or inside the market makers' bid price. That may or may not be the true bid price. What is almost certainly not the market maker's price, however, is the ask price. We see a 4-contract order that is likely inside the market makers' ask price. Unless we intend to sell at the bid and buy at the ask, we want to know the market maker's levels so we can determine a mark that is a viable one. If we calculate the spread between the bid and ask prices on the 1330, where we're fairly certain we're seeing the market maker's levels, we see that it's 4.80 - 3.30 = 1.50. When we look at that 1310, however, we see that it's a much narrower 8.70 - 8.00 = 0.70. While there is likely some slight difference in the spread between bid and ask on options with strikes 20 points apart, it's likely not that big a difference. Probably once those four contracts are filled, if they are, the ask will widen again to the market maker's, and the mark for that option will rise. In turn, that will make the vertical spread's mark rise, too. Since we can theorize that the 8.00 is correct, which may or may not be a correct assumption, we could then add an estimated 1.30-1.50 to that price to calculate what the true ask might be. From there we can calculate a theoretical mark for the vertical. Someone placing an order to buy-to-cover that spread at 4.30 was likely not going to have an order filled because that trader might have been offering too low a price. That spread's mark might still have been close to the original 4.75 or perhaps slightly lower. Someone who had to work an order to buy-to-cover that spread from 4.30 all the way up to 4.60-4.75 before getting filled would likely have complained that the market makers weren't filling those spreads anywhere near the mark that day. The true trouble would have been that the mark on which they'd priced the order was not going to be an executable price.
Sometimes both the bid and ask sizes will be small and likely inside the true bid and ask price. How can the trader then determine the true mark? Scanning nearby option strikes can help, particularly if the two strikes on either side of the one being studied have those large and even-numbered bid and ask sizes. If a strike on one side has a mark of 5.00 and the one on the other side has a mark of 3.00, we can assume that the one between them likely has a true mark somewhere around 4.00, although perhaps not exactly at 4.00.
Going through these examples will not guarantee that you'll be able to get good fills in fast market conditions, but they certainly help traders to start plumbing for a fill. Some traders will place a one-contract order to plumb for that correct price, then send the rest of the order through once they know the price, as long as the market isn't moving around too fast. This won't work for those traders who pay a flat fee, as they'll pay commission costs through the nose to plumb for correct prices. Even once traders know where the correct price is, some traders will break up larger contracts into smaller sizes as they believe they get quicker fills on orders under 10 contracts due to the differences in the way smaller and larger contracts are handled in the complex order book. For example, they might break up a 15-contract order on the SPX into an 8-contract one and a 7-contract one. I've heard people from the floor in the SPX pit who say that there's no need to do that, so I'm not sure whether it's helpful or not. I tend to just send in my whole order.
Those are a few observations from Thursday, October 27. As painful as that day was for many, it can also be a learning experience. I had talked about some of these ideas in prior articles, and I wanted to pull some real life examples from that day to illustrate them.