In order to trade options most efficiently a trader must think like a market-maker. The goal of the market-maker is always to get the best value possible. While traders focus on Charts, Fundamentals and developing other market biases, once they have completed their analysis and are ready to trade it is the time to utilize market-making skills to enhance value. This skill involves looking at a series of options in order to get the best value for your transaction.
If, for example, you wanted to sell the 208/209 Call Spread in SPY (S&P 500 ETF Trust) for 67 cents but the market was 65 Bid and Offered at 66, what alternatives might you have? You could leave your offer in or you could look and see where the Put Spread was trading. Since the market is very efficient, in all probability the Put Spread was trading 34 Bid and Offered at 35. As market-makers know, Put Spreads and Call Spreads are the same thing. They have an inverse relationship. If, however, you could buy that Put Spread for 33 then you would have completed your objective and could withdrawal the Call Spread offer.
Whenever you make trading decisions, understanding the relationships of the options and why one option or spread is better than another, can help you get better value. As a market-maker who understood the relationship of options through conversions, reversals, butterflies, boxes and implied volatility plays, I was able to get an extra advantage when making trading decisions. These relationships are not that complicated, but by understanding them a trader can certainly save themselves plenty of money setting up their positions.
In markets like SPY (S&P 500 ETF Trust) or E-mini S&P 500 Options, analyzing the implied volatility skew, coupled with some of the techniques mentioned above, provides interesting trading opportunities. Market-makers enjoy trading illiquid markets because they get a significantly larger edge on each transaction. Don’t make the mistake of trading illiquid markets. SPY and the E-minis provide the liquidity needed to establish positions efficiently. Analyze the markets you’re trading and see how its liquidity compares. Always compare how the Bid or Offer you are establishing compares to the other Bids and Offers in the series. By merely comparing the value of spreads and butterflies around it, you get an excellent idea of the value you will attain. The example below shows a classic mispricing of options if you take the midpoint of the Bid and Offer: can you find the option you wouldn’t want to sell?
The 95 Put is the Strike Price that is over-priced. If you can buy the 100/95 Put Spread for .20 and sell the 95/90 Put Spread for .25 then you have established the butterfly for a credit. Our Options Guide reviews many of the essential elements of options valuation. We have a couple of PDFs that can improve your understanding of options valuation. If you are interested in learning in an individual options training webinar, we’ll focus on the trading skills that will save you money. If you are evaluating spread prices, liquidity, the price of the surrounding butterfly spreads, historical and implied volatility, the skew and choosing the appropriate options trading strategy to meet your goals, you are making the effort that market-makers do when evaluating trades.
Options trading involves significant risk and is not suitable for every investor. The information is obtained from sources believed to be reliable, but is in no way guaranteed. Past results are not indicative of future results.