"Why do we hate to bargain? Westerners, I mean. I suppose because it implies that a falsehood is the basis of the transaction--the first asking price is a lie," decides the main character of the novel Lulu in Marrakech
(Johnson, Diane; Dutton: 47).
I'd just read those words when I overheard another conversation, this one about whether a "bargain" in an options trade was truly a bargain. How can some traders get fills at or near the mark, while some claim they can't and some claim they get filled at better than mark, implying they got a great bargain?
Sometimes a momentary blip in prices, so quick it never registers on the screen, a similar blip in volatility or an errant order somewhere out there in cyberspace provides that seemingly better-than-mark fill. In those cases, the trader might actually have gotten a bargain. However, the cause usually lies elsewhere. The answer can often be found by following a procedure that many options traders follow. I was first taught this procedure by a previous Option Investor writer, way back in the early 2000's, but I often hear active traders talking about it now, too.
Let's begin by taking a look at the bid/ask spreads and their sizes for a few options in the SPX chain. This snapshot was taken at approximately 9:43 EST on Thursday, July 21, 2011. I apologize in advance for the dark background, but I wasn't able to pull this information together in the same format in my other brokerage, where I could get a light-colored screen.
TOS Market Depth Screen for Four SPX AUG11 Calls:
This chart includes the bid-and-ask grouping for each option and the bid-and-ask size. We need both for the purposes of this article. First, as we calculate the bid-ask spread, we notice that it's $0.90 for the 1400 call, $0.90 for the 1390, $1.00 for the 1380, but only $0.80 for the 1370. That 1370 spread seems a little tight when compared to the others, doesn't it? That's our first clue. In fact, the 1360, not included on this chart, had an even wider spread than the 1380's, at $1.30. Seems as if the bid-ask spread for the 1370 should have been higher. Logic tells you that the spreads should have been widening as we moved down the chain on this particular day.
That's one clue that if we were to calculate the mark or midprice of that option we wouldn't be coming up with the true mark or midprice. Another clue lies in the bid and ask sizes. Did you already notice that the bid and ask sizes are large and mostly equal on the other options included above? That's a sign that these are market makers setting their bid and ask prices. However, we see an ask size of "1" for the 1370 call. Likely, a retail trader has put in an order to sell that option, with the asking price inside the market maker's price. If you wanted to snap up one contract for $7.00, you'd likely get filled if you got that order in before anyone else, but what if you wanted to buy or sell more? What would your price be?
From what we know of the option chain at that moment, the bid and ask were likely at least $1.00 apart at that point and perhaps even further since the next option in the chain had a wider bid-ask spread of $1.30. Let's be theorize that the real bid/ask spread would have been $1.10.
We know because of the bid size that the bid is likely the market maker's bid. To theoretically calculate the true mark or midprice, we'll add $1.10 to that $6.20 bid and come up with a theoretical ask of $7.30. The theoretical mark or midprice would be ($6.20 + 7.30)/2 = $6.75. It had appeared to be ($6.20 + $7.00)/2 = $6.60, but that was likely not the true mark.
Imagine that someone had owned 10 contracts of that 1370 and had decided to take advantage of the morning gap higher in the SPX and sell that option. Maybe that person thought that the SPX might continue climbing and so even put the order in for $6.70, ten cents above the apparent mark, just in case she could catch the tiptop price. Perhaps that order was filled the moment the "send" tab was clicked, and the trader congratulated herself for the great price she had wrestled from the market makers. In truth, she sold for what was a nickel below our theoretical mark or midprice. With the SPX, that was the best price she was going to get at the moment, since we're not allowed to put in an order for $6.75. It was a good price but not a particular bargain. She certainly didn't get the $0.10 above mark that she thought she did.
The trader who thought the markets were headed higher that morning and put in an order to buy at the apparent mark or midprice of $6.60, upping the offer to $6.70 a few minutes later might have been disappointed when no fill occurred. His offer was, after all, only $0.30 below the apparent offer price. In truth, it may still have been below the true mark or midprice.
What if the trader had planned to include that option in a spread? Similar calculations would have to be made. I usually calculate the mark or midprice of several spreads around the one I intend to sell or buy as a quick reassurance that I'm putting in my order where it should be. I also put my spread up in the Market Depth window and check to see if there are any errant small orders out there changing the mark or midprice to something that's not going to be the true mark or midprice.
This procedure isn't a guarantee that you'll always get a quick and good fill or will always avoid a bad one. Market conditions mean that we sometimes have to move far from the mark or midprice on our orders. Adverse conditions may occasionally even mean that we have to leg into or out of spreads, although I don't recommend that tactic at all in these market conditions.
Still, we need as many tools in our arsenals as we can find, and this is one. Unfortunately, I can't help you figure out how to get this exact information on your platform as I'm not familiar with all platforms and not particularly good with software, even if I were. Call and ask your platform's help desk, however.