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Calculating risk with large bid ask spreads?


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Calculating risk with large bid ask spreads?

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  #1 (permalink)
 Tuglife 
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I just watched an informative video about selling credit spreads on VIX futures. There was an element about the video I don't understand. The host was explaining his strategy, Sell X, buy Y. But in his example, the prices he used were both "ask" quotes. The "bid" quotes were quite different, of course.

So there is the meat of the question. When calculating an options position, even a naked put or call, how does one calculate risk if the entry price is uncertain?

And also, what is the best order execution method? I have only bought a few calls in my career and I simply used limit buy orders and walked them up, starting at the "bid" quote on my platform.

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 SMCJB 
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Good Question.

Bid-Ask spreads in options are often a significant cost of trading as they are often much wider than the underlying product. Factor in that these products also have smaller delta's and you often need a much bigger price move to just cover the spread.

In terms of risk, if you entered the position and then immediately closed it with no market move at all you would expect to lose (ask-bid+commissions)*2. Now consider the following hypothetical situation. Stock is trading $100 and you buy the ATM Call. If the stock goes to $99 you stop yourself out and if goes to $103 you take profits. Hence you think you have a 3:1 reward to risk ratio. Assuming 50% delta, if stock goes to $99 you lose $.50+(ask-bid+commissions)*2 and if stock goes to $103 you make $1.50+(ask-bid+commissions)*2. If bid-ask + commissions is actually say 10c this becomes -$.50-$0.20 = -$0.70 and $1.50 - $0.20 = $1.30. hence your 3:1 reward to risk trade is actually 1.85:1! Obviously only hypothetical, but hopefully a good illustration.

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 Tuglife 
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I feel foolish for posting this question and then not watching for a reply.

Your answer discusses how badly a large bid/ask spread can affect your position, but doesn't really address the idea that one can walk up a bid, or walk down an offer.

When a good options trader looks at trade entry or exit do they look at buying at the offer and selling at the bid (in terms of estimating P & L) because that's where the fill is guaranteed? And then "maybe" things can work out better?

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 SMCJB 
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Yes if you enter an order in between the bid and ask you have a chance to get filled at that price. In lots of markets with a wider bid-ask I find that if you enter a bid one tick below the ask you will often get filled immediately. Not always the case though. For example in a lot of the CL longer dated Calendars (thinking Dec27-Dec28 etc) if you enter an order between the bid and ask and the bid/ask is a market maker, they will often move their market away from, making your potential fill worse.

Note that when you start talking about structures (eg a call spread) there is nearly always an exchange listed spread, or user defined strategy, where you can trade that call spread as a single order, and the bid/ask on that will probably be tighter than either one of the calls by themselves individually never mind combined.

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 Tuglife 
Escondido CA USA
 
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Quoting 
Note that when you start talking about structures (eg a call spread) there is nearly always an exchange listed spread, or user defined strategy, where you can trade that call spread as a single order, and the bid/ask on that will probably be tighter than either one of the calls by themselves individually never mind combined.

Wow. Thank you for this info...it increases the chance that I can implement my ideas.

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