How To Execute And Fill Options Trades

Filling option trades can often feel like pulling teeth. While some trades and orders get filled quickly and without issue, others are incredibly stubborn and hard to get filled. To add to your frustration, the entire order execution process appears to be just another confusing black box. There’s seemingly no rhyme or reason why this trade got filled, but that one didn’t. This week’s show is dedicated to shining a light on order filling for option trades and demystifying what is otherwise a simple market process.

To understand the order entry process, getting trades filled, and why they might not get filled, we first have to understand some key concepts regarding market liquidity to frame our discussion.

1. Market Makers

  • Markets need to be made in products. Market makers are there to make a market for you. They can be thought of like warehouses such as Walmart. (See Episode 169 and Episode 147 where we interview market makers).
  • Walmart makes a lower spread on products that are easier to sell and require repeat purchases. There is more liquidity in this domain of products versus more niched ones that are more expensive.
  • Most of the issues with filling trades come down to liquidity. If there are many players in the market and a lot of liquidity, it’s easier for market makers to make a market and easier for you to get trades filled. The opposite is true, too.

2. The Bid/Ask Spread

  • First, we have to break down the individual bid/ask spread components. The bid is the highest price that someone is willing to pay to get into an option contract at this exact moment. The ask is the lowest price someone is willing to sell the contract at this exact moment. Those two numbers create the bid-ask spread. It is the difference between where buyers and sellers are right at this moment.
  • The bid is always below the ask. The highest price people are willing to pay to buy something is always lower than the lowest price the people who own it are willing to sell. So, you can’t buy something and then sell it off for an immediate profit.
  • Either the buyer or seller has to give (change their bid/ask price) for the trade execution to occur. If nobody gives, the bid-ask spread stays where it is.
  • An Illiquid Market with Wide Spreads
    • Let’s assume we’re looking at an option contract and the bid price that we see on the contract is $2.50, and the ask price is $3.00. This means the bid/ask spread is 50 cents wide.
    • You might see a mid-price of 2.75 here, meaning the buyers have come up 25 cents and the sellers, down 25 cents, and a transaction occurs. Things don’t always happen in this way, but if they do, you’d say the transaction settled at mid-price.
    • The wider the spread, the more a hurdle the buyer and seller have to jump over to meet in the middle.
    • A spread like this alleviates much of the need or ability to have an arbitrage opportunity (buying and then selling immediately for a profit). If you bid at 2.50 and the seller didn’t budge from 3.00, you’d need to go all the way up to 3.00 to get the position filled if you wanted it immediately. Selling it off immediately would mean taking a loss. The next bidder behind you is still sitting at 2.50 or less. This works both ways.
    • Let’s assume in the best-case scenario, you get filled at the mid-price, which is 2.75. You still are in a situation where you have a 25 cent hurdle to get over before you make money.
  • The Town House Analogy
    • Ten townhouses are being sold for $300,000 each by ten different sellers, and ten buyers all only willing to pay $250,000 for a house. If one buyer and seller negotiated to meet in the middle and transact at $275.000, and if that buyer decided to try selling the house they just bought immediately, the entire market (the other nine buyers) would have to raise their bid by an excess of $25,000 for that seller to start making money.
    • The likelihood of this happening is low, meaning the chance of the buyer making money immediately off this deal is low.
  • Why Narrow Spreads Mean Higher Likelihood of Filling Orders
    • The more narrow the spread becomes, the higher the liquidity, and the easier filling the orders becomes. A situation gets created in which you don’t have to overcome such a large hurdle to make money on the position.
    • This is in contrast to a wide bid/ask spread, where it’s tough to get filled because there’s less liquidity. You have to jump a large hurdle to make money because the next highest price that somebody will pay for the position you just bought at 2.75 (in our example) is 2.50 or less.
    • Jumping this hurdle requires things to happen for that option price to change, such as the stock moving in the right direction, a spike in implied volatility, etc.
    • So, with wide spreads, a lot needs to happen for the position to get back to breakeven compared to narrower spread positions.
  • Example 2: A Liquid Market with Narrow Spreads.
    • Let’s imagine a narrower market where the bid/ask spread is only 10 cents wide. The bid price is still 2.50, but the ask price is 2.60, making the midpoint 2.55.
    • The hurdle for both buyer and seller to jump to transact in the middle is far less.
    • The transaction is more attractive because you only need the market to move up by five cents to make money.
    • A quick move in the market, a quick move in the underlying security or implied volatility can allow you to make money in a tight, very liquid market with narrow spreads.

3. Volume and Open Interest

  • Volume and open interest dictate the bid-ask spread.
  • Volume refers to the number of contracts that are traded today. Open interest refers to the contracts that are still outstanding.
  • Volume can be thought of as activity in the market, and open interest, the depth of the market. Looking at a market’s volume and open interest should give you a better idea of how active and deep the market is. Looking at the market in terms of one or the other won’t give you an accurate picture.
  • If you have high liquidity, judged by volume and open interest both, that takes care of 90% of the issues with filling trades. This is because high volume and open interest create more narrow spreads, which are less risky, so it’s easier for people to get transactions filled.
  • Volume and open interest take care of a lot of the bid/ask spread complications.

4. The Difference Between Filling Simple and Complex Contracts (Single Contract Versus Spread)

  • Most people assume that a complex trade is harder to fill, and it doesn’t have anything to do with the legs.
  • It may in some cases be easier to fill more complex trades, though, because they can have very little risk with market movement, meaning the person on the opposing side doesn’t have a lot of risk that that position is going to be a dramatic winner or loser today as the market moves.
  • For example, if you’re entering a really wide iron condor on SPY, it might be a lot easier to fill even though it has more contracts. With the iron condor, you might set it up to be delta-neutral, such that market movement today, because the contracts a month or so out, really has little to no impact on the pricing.
  • In contrast, if you were making an aggressive trade that’s at-the-money and only one-sided, like a short call, short put, long call, or long put, the one contract doesn’t mean it’s easier to fill. It might be harder to fill because there’s more risk associated with somebody getting it wrong, so they might be more aggressive or firm with their pricing.
  • Simple orders are not necessarily easier to fill. What you should be thinking about is how complex the risk is, how complex is the transaction cost associated with it and that might dictate why orders are easier or more complicated to fill.

Six Quick Tips to Help with the Filling Process

  • Now that the discussion has been framed with the four concepts, it’s time for some tips that will help you potentially get better fills, execute fills faster, and handle the entire filling process more easily.
  • We have to bear in mind the tradeoff between the best price and the fastest execution. You might have to give a little bit on price in order to get the trade filled faster or vice versa.

Patience pays

  • When you are executing trades, it is really important to be patient and not chase the market. This means that when you place an order, you shouldn’t immediately readjust it when the market changes. Place an order and let the market trade around until you find a willing buyer or seller.
  • If you place an order and the market price gets better but you don’t immediately find a buyer, it just means that you haven’t yet found the perfect person for the opposite side of your trade.

Follow Liquidity

  • The 80/20 principle is in play here, meaning that 80% of your issues in getting trades filled probably result from not focusing on tickers with high liquidity.
  • If you follow the most liquid tickers, it will become easier to get trades filled and have better prices because the spreads are lower.

Use the BEST Exchange

  • If you place an order and tell Thinkorswim or TD Ameritrade to route it directly to the CBOE, that means the order is only sitting on the CBOE. The order is not being entertained at any place else, even though another exchange might have a better price. So, it is good to tell your broker or set your platform to route to whatever exchange has the best price looking to get the best fill.

Go Fishing

  • The idea behind going fishing is not to give the market your entire order right away. If you have an order of five contracts, start with just one contract at a slightly aggressive price. If it gets filled instantly, you know the market is aggressive and can try another contract at a more aggressive price.
  • This can help you scalp a couple of dollars here and there on your order execution.
  • If you didn’t do it this way, and instead did all five contracts at the mid-range price, and they all got swept up, then you might be left wondering whether you could have succeeded at a higher price.

Legging Carefully

  • We already covered the point where more legs don’t necessarily mean harder to fill.
  • Legging into trades where you split the orders by doing one leg and trying to do the other – essentially manipulating your order entry such that you get into the trade faster – might result in not being as quick and nimble to get into the same price, had you just tried one complex order and been more patient.
  • This doesn’t mean legging is bad, just that it should be done carefully.

Adjust Your Position and Price Slowly

  • Chasing markets is common, and many people feel they become prey to market maker predators when they chase price. Then they get slammed back down in price after they get filled.
  • Enter an order and let it go for 30 minutes to an hour. Let the market trade around it. If there’s a compelling reason to change the price, adjust it slowly.
  • If you’re trying to buy an option contract for 2.50 and the mid-price is now 2.60, that doesn’t mean you have to move up to 2.60. You can move to 2.55 and might get filled instantly upon doing that.

Try Tomorrow

  • Often, people feel so compelled to get into a trade today when there will always be more opportunities tomorrow.
  • Try today at a couple of different prices, but don’t stress yourself to get into a position. If you’re trying at 2.50 and then in the afternoon the price moves to 3.00, don’t chase it all the way just to get into the trade today.

Final thoughts

There are a lot of different moving parts here, but the entire process is actually relatively simple. There are a couple of big levers that you can pull by playing in the big liquidity pools that take care of 90% of the issues for order entry. The other 20% is about a lot of patience, tweaking orders, going fishing, and using the best exchange.

Option Trader Q&A w/ Max

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Max:

Hi, Kirk. This is Max from Switzerland. My today’s question is about how many times do you think you should test a new strategy on the demo account before starting using it on the paper trade? Thank you very much.

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.