THE WIDOWMAKER
A lot has been said recently about the infamous 'widowmaker' trade; shorting Japanese Government Bonds (JGBs) with the expectation that the nation's mountain of debt will inevitably blow out JGB yields. The thesis sounds solid but the reality is that the Bank of Japan is so hellbent on igniting inflation with the hopes of waking the long-hibernating economy that it has recently sent yields into negative territory. Think about what that means; Japanese savers are essentially paying their banks to hold their money. As a result, traders have gotten killed waiting for spread widening... hence, the 'widowmaker' moniker.
If we think about all of the factors that make options trading so difficult (and there are plenty to chose from), there is one that often goes overlooked... liquidity. Liquidity is most evident in the bid/ask spread of any traded instrument. It's generally true that the more an instrument is traded, the more liquidity it will have... or another way to put it, the more an instrument trades the smaller the difference between the bid and ask prices.
YOU HAVE TO PAY TO PLAY
If we look at the SPY ETF, even on a wildly volatile day (like today happens to be) the spread is as thin as its gets... 1 cent between an offer to buy and an offer to sell. Even the spreads on the SPY options are thin.
Last Friday, I put on a 1 week 200/195 bull put spread with the expectation that the SPY would fill the gap between the 20 and 50 day moving averages... the payoff is 6-to-1 on my risk (I should probably say 'the payoff was' because it'll probably take a 2 sigma 3 day move to get me out in the money at this point). If I choose to exit the trade early and buy the 200 put, I can exit by taking liquidity and paying $9.79 which is the current offer price. Or, I could try to bid on the option in hopes of paying a lower exit price; the current bid is $9.60. Regardless, the 19 cent difference in price - or the spread - is relatively low to the price of the option.
But what happens when spreads become significant? A failure to account for the impact of pricing differentials can create widows without the help of interventionist monetary policy.
Spreads are a reality of trading. In actuality, they represent a huge benefit to investors because they signify that any exchange traded instrument has a buyer or seller on the other side of a trade that is obligated to fill an order. These obliged souls are the market makers and before we canonize them for their noble dedication to capital markets, let's keep in mind that they tend to make a pretty penny for their services. Market makers don't take any exposure to market or volatility direction; instead they make their living by capturing spread differentials in the products they specialize in. We, the investors, pay that spread... it's the price of doing business.
Looking back at our example on the SPY $200 put option, the 19 cent spread was less than 2% of the offer price on the option... not a big deal. Now let's look at what happens when a product has very little liquidity and much wider spreads.
Back in September, I wrote a blog titled, 'The Biotech Selloff is Just Getting Started and What That Means for the Broader Market...'
http://tancockstradingblog.blogspot.com/2015/09/the-biotech-selloff-is-just-getting.html
...and while it took a while for that selloff to pick up steam like it has now, there have been no shortage of bearish opportunities in the meantime. One such opportunity has been Mallinckrodt (MNK); see the 6-month chart:
Today, MNK posted a better than expected earnings number for the fourth quarter of 2015. Not surprisingly, the price rallied but only reverted to its 50 day moving average. The technical setup looks like a potential bearish opportunity; especially as the broader market fails to consolidate.
If we look at the price of a 4 week, at-the-money, put option on MNK we'll see that the March 4th $66 put has an offer price of $5.30 and a bid price of $4.10. That $1.20 spread represents more than a 22% spread to the offer price. What's more, the relative difference in implied volatility associated with the spread isn't 22% but more than 30%.
It's important to note that there is no open interest in this option and very little in any of the other strikes for the same expiration date. Hence, there is very little liquidity.
WHY PAY RETAIL PRICE WHEN YOU CAN HAGGLE
Any effective trader who wanted to buy this option would most certainly bid on the put before entering a limit order for the offer in the hopes of not paying the full retail price. However, there's a good chance that any bid would have difficulty getting filled because the market maker wouldn't be able to offset the risk by buying the option from someone else. Most likely, he or she would have to delta hedge the option and warehouse the risk until it expires.
To get a visualization of the implication of spread pricing, let's look at price dispersions associated with the offer price, the midpoint and the bid price.
The offer price of $5.30 has an implied volatility of 65%:
The midpoint price between the bid and the ask is $4.70 which has an implied volatility of 57.5%:
Finally, the bid price of $4.10 has an implied volatility of 49.9%:
The differences in the pricing dispersions are significant and show how dangerous it can be to trade in illiquid options. Consequently, the projected volatility for this stock over the time period is roughly 45%.
Here's a link that explains how my model projects prices for added clarity on these charts:
http://tancockstradingblog.blogspot.com/2015/08/projecting-equity-prices-using.html
When placing orders, traders have to be mindful of what they're paying for relative to reasonable expectations... the failure to do so can result in a lot of pain.
A lot has been said recently about the infamous 'widowmaker' trade; shorting Japanese Government Bonds (JGBs) with the expectation that the nation's mountain of debt will inevitably blow out JGB yields. The thesis sounds solid but the reality is that the Bank of Japan is so hellbent on igniting inflation with the hopes of waking the long-hibernating economy that it has recently sent yields into negative territory. Think about what that means; Japanese savers are essentially paying their banks to hold their money. As a result, traders have gotten killed waiting for spread widening... hence, the 'widowmaker' moniker.
If we think about all of the factors that make options trading so difficult (and there are plenty to chose from), there is one that often goes overlooked... liquidity. Liquidity is most evident in the bid/ask spread of any traded instrument. It's generally true that the more an instrument is traded, the more liquidity it will have... or another way to put it, the more an instrument trades the smaller the difference between the bid and ask prices.
YOU HAVE TO PAY TO PLAY
If we look at the SPY ETF, even on a wildly volatile day (like today happens to be) the spread is as thin as its gets... 1 cent between an offer to buy and an offer to sell. Even the spreads on the SPY options are thin.
Last Friday, I put on a 1 week 200/195 bull put spread with the expectation that the SPY would fill the gap between the 20 and 50 day moving averages... the payoff is 6-to-1 on my risk (I should probably say 'the payoff was' because it'll probably take a 2 sigma 3 day move to get me out in the money at this point). If I choose to exit the trade early and buy the 200 put, I can exit by taking liquidity and paying $9.79 which is the current offer price. Or, I could try to bid on the option in hopes of paying a lower exit price; the current bid is $9.60. Regardless, the 19 cent difference in price - or the spread - is relatively low to the price of the option.
But what happens when spreads become significant? A failure to account for the impact of pricing differentials can create widows without the help of interventionist monetary policy.
Spreads are a reality of trading. In actuality, they represent a huge benefit to investors because they signify that any exchange traded instrument has a buyer or seller on the other side of a trade that is obligated to fill an order. These obliged souls are the market makers and before we canonize them for their noble dedication to capital markets, let's keep in mind that they tend to make a pretty penny for their services. Market makers don't take any exposure to market or volatility direction; instead they make their living by capturing spread differentials in the products they specialize in. We, the investors, pay that spread... it's the price of doing business.
Looking back at our example on the SPY $200 put option, the 19 cent spread was less than 2% of the offer price on the option... not a big deal. Now let's look at what happens when a product has very little liquidity and much wider spreads.
Back in September, I wrote a blog titled, 'The Biotech Selloff is Just Getting Started and What That Means for the Broader Market...'
http://tancockstradingblog.blogspot.com/2015/09/the-biotech-selloff-is-just-getting.html
...and while it took a while for that selloff to pick up steam like it has now, there have been no shortage of bearish opportunities in the meantime. One such opportunity has been Mallinckrodt (MNK); see the 6-month chart:
Today, MNK posted a better than expected earnings number for the fourth quarter of 2015. Not surprisingly, the price rallied but only reverted to its 50 day moving average. The technical setup looks like a potential bearish opportunity; especially as the broader market fails to consolidate.
If we look at the price of a 4 week, at-the-money, put option on MNK we'll see that the March 4th $66 put has an offer price of $5.30 and a bid price of $4.10. That $1.20 spread represents more than a 22% spread to the offer price. What's more, the relative difference in implied volatility associated with the spread isn't 22% but more than 30%.
It's important to note that there is no open interest in this option and very little in any of the other strikes for the same expiration date. Hence, there is very little liquidity.
WHY PAY RETAIL PRICE WHEN YOU CAN HAGGLE
Any effective trader who wanted to buy this option would most certainly bid on the put before entering a limit order for the offer in the hopes of not paying the full retail price. However, there's a good chance that any bid would have difficulty getting filled because the market maker wouldn't be able to offset the risk by buying the option from someone else. Most likely, he or she would have to delta hedge the option and warehouse the risk until it expires.
To get a visualization of the implication of spread pricing, let's look at price dispersions associated with the offer price, the midpoint and the bid price.
The offer price of $5.30 has an implied volatility of 65%:
The midpoint price between the bid and the ask is $4.70 which has an implied volatility of 57.5%:
Finally, the bid price of $4.10 has an implied volatility of 49.9%:
The differences in the pricing dispersions are significant and show how dangerous it can be to trade in illiquid options. Consequently, the projected volatility for this stock over the time period is roughly 45%.
Here's a link that explains how my model projects prices for added clarity on these charts:
http://tancockstradingblog.blogspot.com/2015/08/projecting-equity-prices-using.html
When placing orders, traders have to be mindful of what they're paying for relative to reasonable expectations... the failure to do so can result in a lot of pain.
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