Trading Illiquid Option Markets

You Against the Market Maker

Illiquid Markets
Non-Liquid Markets. Google Images

While the options market changes fast, some information can still be useful for traders years later. In 2007, someone asked the following question

I am trying to establish a position in an option that it not very liquid. It's so illiquid that I am the only person trading these options. Every time I place an order it is partially filled, then the price is bumped higher. My orders alone have caused the price to double from $.40 to $.80. The options started off no-bid, offered at $.40. Now the option market is my bid, offered at $.80. Am I better off placing one large order or several smaller orders to enter the trade efficiently? How can I avoid having my own orders drive up the price?

My Reply: These questions are reasonable for an inexperienced trader. The reply contains some very basic — and obvious — ideas that I urge you to understand before you attempt to earn any money by trading options. 

At the outset, let me state that you cannot continue to trade options on this underlying asset, unless your goal is to throw your cash into the garbage. 

1. You cannot avoid seeing your orders drive up the price because there is no traditional market here. There is no supply and demand. It is only you (the only buyer) and the market maker (MM) who is the only seller. That market maker can ask whatever he wants to ask because there is no competition. It does not matter whether you enter one larger order of several smaller ones because you cannot coerce the market maker to sell more options than he wants to sell. Conclusion: Stop trading these options.

2. When you buy an option, the primary method for earning a profit involves selling that option at a higher price.

I know that seems trite, but it is the mechanism by which trading works. If you are having so much difficulty, and frustration, when buying the options, imagine how you will feel when the time comes to sell. The MM will drop his bid and you will never be able to sell at a reasonable price. When that market maker knows that no other trader will come along to buy your options, he can bid whatever he want to bid.

Your only choices will be to sell at the MM's price, or hold onto the options. This is a bad deal for anyone.

Yes, you can hope to make money when the stock price soars higher (I assume you are using call options, but a similar argument applies when buying puts) and the option moves far into the money. If that happens, there is no need to sell the options and therefore, no need to be concerned with the market maker. In that scenario, exercise the option (before it expires) and immediately sell the stock. In this situation, you cannot be denied your profit by the MM. However, unless you are a spectacular stock picker, these large increases in the stock price will be quite rare. Do not depend on earning money this way.

When buying options, the plan is to sell those options at a higher price to generate a profit. But the MM is the only buyer, and is not forced to bid an attractive (to your) price. That is how a monopoly works.

If you change your mind on the future direction of the stock price, and want to salvage a portion of your investment, you must be able to sell those options, even at a loss. In this scenario, no one will buy your options. If your expectations (big rally fail to come true, you would lose 100 percent of your investment when no trader is willing to take the position off your hands.

Thus, because you must depend on selling your options, there must be someone to buy them. In your example, there is no other person to whom you can unload the position, except the market maker. Most of the time, market makers do a fine job and offer reasonable bid and ask prices at which you can trade. However, that is clearly not true with the example cited. Remember that the MM can act this way only because there is no liquidity. 

This is not viable. The situation ought to feel so bad that you would never buy options on this stock — at least not until they become far more liquid. If you truly expect the stock price to soar, ask yourself: Is your track record so good that you can afford to wager cash when the odds of earning a profit  are stacked against you.

This MM has no interest in trading the options.

That is obvious from a zero bid to an asking price of $0.40. The fact that you would even consider paying that $0.40 demonstrates that you do not yet grasp the concept of ever getting out of this trade. Sure the option market looks good with your purchase price being the bid. But, as soon as you try to hit the bid, it will disappear and the market will revert to no bid; $0.40 asked.

3. Liquidity is essential. Repeat: Liquidity is mandatory. You have no chance to win when you are the only trader, or even when you are one of few. If the market maker(s) do not offer a tight (i.e., narrow) bid/ask spread, then you should not trade the options. If you have very strong feelings about the direction of an upcoming stock price change, then trade stock. I know that options offer great advantages over trading stock, but when you cannot get a fair deal when buying and selling the options — when there is no one to take positions off your hands at a reasonable price — then it is highly unlikely that you can come out ahead. If the MM does not maintain a fair and orderly market where participants get a fair shot, then do not do business with him. Do you go back to a restaurant with rude wait staff or terrible food?

4. It is reasonable for large orders to move markets. However, it is unreasonable for your order to bump the asking price so far. If the new ask were $0.45 or $0.50, that would be acceptable, and a common, occurrence. This MM does not want to sell these options at any price, and his $0.80 offer should make that clear.

5. Buying out-of-the-money options is usually a poor strategy. Especially in this example where there was no bid until you arrived on the scene. Unless the stock undergoes a very large price change, the bid (when your buy order is absent) is going to revert to zero, or near zero. And you can be confident that as soon as you try to sell the options that you own, the bid will be zero. Of course, if the MM who sold those options to you wants to cover his position, then he may bid $0.05 or $0.10. However, there is no chance that he will provide a fair bid when he knows that no one else will ever make a bid for your options. In other words, the extreme non-liquidity of these options assures the MM that he is the only bid and that he has no competition. In that world, he does not have to make a serious bid because his is the only bid.

Most market makers do a good job and, despite being in the game to make money, will give you (and other traders) a reasonably fair deal. However, when the bid/ask market behaves as it does in this scenario, know that this is a bad market maker and that you are doomed to lose money if you do business with him. You cannot get a fair price from someone who does not want to make a market (i.e., buy and sell) these options.

6. When you see a narrow bid-ask spread, such as $0.60 to $0.65 or even $0.60 to $0.70, you know that it is relatively safe to enter the fray. However, when the bid/ask is wide — and especially when the bid is zero — you should avoid playing. 

In your example, the ask price was $0.40. That is outrageous when the bid is zero. The 40-cent wide spread is unusual and is a blatant warning that the game (in these options) is rigged. Look at what happened. You bid the ask price and bought some options. Question: Do you have any idea of the true value of these options? Did you use an option calculator to get a reasonable estimate of what the option was worth? Do you have an idea of what factors determine the market value of an option, or did you just  buy these options because you were bullish on the stock? Let me assure you that buying the wrong (i.e., the option that is not the best for your outlook) is the number one reason that option buyers lose money.

Now that you are bidding $0.40 for more options, the MM raised the offer to an unbelievable level of $0.80. I guarantee that if you had the slightest idea of how to value an option, you would understand that 80-cents is not a real-world price. Your question makes it seem as if you would consider buying more at that elevated price, but I hope that you would never do that unless the stock price zoomed higher and that $0.80 represented a reasonable value for that option. 

Just because the offer is 80 cents, it does not mean that you must (or should) pay 80 cents to buy options. It is almost never right to pay the asking price when buying options. Instead, a trader should enter a limit order with a bid that is above the current bid, but below the current ask. That plan works often enough that it will save you a lot of money over your trading career. In this case, you would not be able to buy the options. But that is a good thing. 

Stick with moderately to actively traded options. You do not need bid/ask spreads to be only 5-cents wide, but even 20-cents for very low-priced options can be a warning sign.