On Wednesday, June 27, 2012, the RUT zoomed up to touch the Friday, June 22 closing high. Some among you may remember that the RUT had a lot of climbing to do to get back to that high. On that Monday, it had tumbled 1.45 standard deviations, a significant decline in a single day.
I was in a six-contract butterfly. That butterfly had grown some extra appendages after its launch as I controlled the price and volatility risks. It was looking as if I might need to adjust that Wednesday, too, but with 25 days to expiration, I was moving into the mode when I adjusted by taking off portions of positions rather than adding to them. This was especially true when the next day was to bring the Supreme Court decision on the Affordable Care Act and the beginning of yet another eurozone summit. We were still in the end-of-the-quarter window-dressing period, too.
It was clear that shorts were covering ahead of those events. Once the air cleared the next day, that Thursday, would longs join them in buying or would shorts add to their positions as the RUT and other indices headed down again? Chart setups told me only that the RUT and other indices remained in a churn zone. The movements, while violent, weren't particularly predictive of next direction.
Yet when the absolute value of the delta for my beta-weighted position grew too large, I didn't hesitate to adjust. What I did hesitate to do was to sell the butterfly contracts I wanted to sell for the price that was being quoted.
All day, the Greeks of my trade had been way out of whack. If they were out of whack, was it because market makers were rolling up implied volatilities or widening bids? Was it because of low volume? Was the skew of the puts that formed my all-put butterflies . . . well, skewed?
I remembered a topic other traders had been discussing in a seminar in which I'd participated: price discovery. I suspected that the prices I was seeing weren't correct, either, and would settle down into more correct pricing as soon as prices settled for more than a few minutes at a time. Yet, I had to be away from the market, and I didn't have the luxury of waiting.
The mid price (in the exact middle of the bid and ask prices) for the RUT 700/750/800 butterfly I wanted to sell was fluttering between $14.95-15.10, with price most often staying between $14.95-15.00. One tactic of price discovery is to put in a small order and plumb for the correct price. In this case, since I was selling, that meant putting in an order to sell it at a price higher than the mid and seeing if it would fill. Since the Greeks seemed to be so out of whack from what I expected, I put in a really high no-chance-to-fill order, asking $15.50, well above the mid.
Some of you might be thinking that the RUT happened to have moved big right when I put that order in. That didn't happen. I was watching. Chances are that I just happened to be selling my two lots when someone was desperate to buy two and a match was made. That's possible. However, traders who trade in big lots often speak of plumbing for prices and finding prices much better than the quoted ones. One of the tactics they use include putting in one-lots to test for prices, as I did with my two-lot trade, and then pushing through the other orders in lot sizes of nine or less. I just didn't happen to have another big order I wanted to put through once I'd found a good price. Believe me, though, that I was happy to have sold those butterflies for $15.50 rather than $14.95-15.10.
Some active traders put through one-lots on different exchanges, seeing which fills. Being able to do that requires several parameters being met. First, the trader must intend to trade more than a single contract because it's possible that all trades will fill simultaneously. In addition, the trader must be know the exchanges on which the trade can be executed. For example, this link to the Russell Investment pages lists the exchanges that trade various Russell options.
In order to plumb for prices at various exchanges, you must be able to direct your order. Some trading platforms allow this. Others do not. Although the above listing shows six exchanges that trade RUT options, it's possible that not all are available for trading complex trades or not available to you on your platform. For example, on think-or-swim, I can direct RUT butterfly or other complex orders only to the CBOE, ISE, and PHLX exchanges.
In most cases, you'll want to view bid and ask volume at those exchanges you're considering because the best prices are often discovered where trading is liquid with the highest volume available. Think-or-swim allows this via the "Market Depth" option. At the time I directed my order to ISE, it had the highest bid and ask volume. I know from experience that I often have better luck getting fills on my complex RUT trades on ISE than on the other exchanges, although that's not always true, of course.
Think-or-swim has another capability that allowed me to guestimate where I wanted to put that first trial-balloon, no-way-it-will-fill order. Think-or-swim allows you to chart the fills on that same complex order over a period you specify.
Fills of the 700/750/800 RUT Put Butterfly over a 5-Day Period:
This chart shows fills for the butterfly I wanted to sell over a five-day period. During that period, most of the prices were within the horizontal band that I have marked. It was understandable that as the RUT was moving further away from the central strike of that butterfly that day, its price was dropping and so would be in the lower end of that band. The $14.95-$15.10 mid prices that I was seeing were just a little too near the bottom of that band for my comfort, however. I wanted something a little higher, a little closer to the middle of that band. Looking at that chart, I didn't think I was likely to get $16.00 or above, but I thought $15.50 might be worth a try at price discovery.
The yellow oval marks my sell of my two-lot. I don't understand why the candle has a body at all since only my two (see volume at the bottom) butterflies went through at that time and they were both priced at $15.50, not in a range from just below $16.00 down to $15.50, as it appears on this chart. Perhaps that marks supposed bid and ask at the moment, although that's not what was showing up on market depth. That's the point: what was showing up wasn't the only possibility for a fill.
I'm certain some will want to know how to chart the prices on a spread or other complex order. I know how to do it only on TOS. On TOS, the steps are first to right-click on a simulated or actual order you want to view, then choose "Market Depth."
Market Depth Example:
At the top, you see the composite bid and ask information, marked "COMPO." Right click on "COMPO." You'll get a pull-down menu. One of the choices will be TOS charts. Send it to your TOS charts, and it will be ready for viewing under the "Charts" tab. Note that this Market Depth view was snapped after hours, not while I was pricing that butterfly. The bid and ask sizes will not be reflective of typical sizing during the day for a RUT butterfly, and bids and asks are typically widened.
Another absolute requirement before engaging in this type of price discovery is that the market not be moving big. Prices might be bouncing around enough that you get an advantageous price that encourages you to go forward with entry, exit or adjustment, only to have slippage occurring due to the underlying's price movement before you can get the rest of the trade completed. Nor would I pick a light-volume time and expect pricing to stay the same.
I heard anecdotes claiming market makers know that a trader is plumbing for a good price on a prime trade entry day. They fill at an advantageous price then move the price, knowing that the trader doesn't likely want to be stuck with a single contract and will be forced to chase price. Others have refuted such stories. Particularly with the highly liquid options, I doubt that's occurring. There are many of us retail traders who are trading a single contract. Although my butterfly trades are bigger and my iron condor trades used to be much bigger, I often buy one or two spreads to hedge or move a strike that's already part of my position. At those times, I have no intention to fill any trade other than the one I'm attempting to fill at the moment. We retail traders are minnows swimming through the markets. Our trades are swatted away with little attention paid to their implication, purposes or meanings.
Another possible way to engage in price discovery was offered by a long-time iron condor trader. Put up your intended trade several days before you intend to enter it and watch prices. For an iron condor trader, you might be looking at iron condors with sold strikes at deltas near 9 and -9, for example, and 10-point spreads. The underlying's price might move, but you can keep pricing the premium you'll receive for strikes that meet those guidelines. If you get a day when volatility pops and those prices are good, you'll know it. I like the old-school, tactile-reinforcement method of just jotting the prices down. Others set up elaborate spreadsheets that blink lights at them when prices are right.
The last tip is my best one. Get to know your trade and your vehicle. If you jump around, trading a GOOG earning play one week, a SPXPM weekly broken-wing butterfly another, and an OIH iron condor (yikes) the next, you'll never get a feel for how each acts under certain conditions. That's such valuable knowledge.
By the way, I ended up taking off my JUL butterfly position at a loss on July 3. I could perhaps have fought longer and come out at breakeven or maybe even with a profit, but the trade had become more directional than not. I needed a pullback, and I needed it in a market and a vehicle in which such a pullback wasn't guaranteed. I certainly thought the RUT needed to pull back. A fitted Fibonacci bracket showed that the move might be completing for the short term. It was possible that the RUT was going to pull back, as it indeed did do, but it was also possible that if the RUT just kept going, the loss would get bigger unless I was willing to plow more money into the trade. I took the loss and was ready to enter my AUG trade on Friday. Having traded many years, I didn't even feel the woulda, coulda, shoulda that I might have felt early in my trading career when the RUT pulled back. None of this paragraph has anything to do with price discovery, but it does have a lot to do with letting you look over my shoulder as I work with a trade that's relatively new to me. I expected losses, as I do with all trades. I expected those losses to be relatively small, and this one was only 4.25 percent of the maximum margin or buying-power effect ever in the trade. That's the key to keeping this trade on a profitable projectory over the long term, keeping losses small when they occur and producing more profitable than losing months.