Options and Liquidity Providers

Most of you are very familiar with buying and selling stocks and futures. Sadly most of you also love to take liquidity from the market by using market orders, or limit orders that buy at ask and sell at bid.

Taking liquidity is never a good idea, in fact all of the exchanges penalize liquidity takers by adding extra commissions/charges on them. The only times when taking liquidity is acceptable is when the bid/ask spread is already at the min tick size (in other words there is no way to get between the bid and ask) or when immediate execution of the order is a must (you need to get rid of your position at any cost).

Bringing the liquidity taker mindset to options trading is a bad idea, borderline terrible. Options are derivatives and because of their implementation complexity (too many strikes, too many expiration dates) an individual option has substantially lower liquidity than the underlying. This lower liquidity translates into wider bid/ask spreads even for very popular options (like SPY or SPX ATM strikes) which makes taking liquidity a losing enterprise. If you come to the option world and start trading them with market orders you are almost guaranteed to lose lots of money on “slippage”, perhaps even more than the profit you were expecting to make. 

This problem is even worse when using Complex orders, which are the ones that I favor in this room the most: Verticals, Butterflies, Calendars, Iron Condors. Because they are even more complex than single options their bid/ask spreads are incredible wide.  

So from this moment on I would like all of our G.O members to stop being liquidity takers when dealing with options. Never ever use a market order for options, or limit order when you buy at ask, and sell at bid. No matter if it is a lonely option or a complex 4 leg iron condor, always use limit orders near mid price (mid price is = (bid+ask)/2). If you want to “grease” the transaction when buying then use mid+grease (a few cents of encouragement), and when selling use mid-grease. 

In the options world you always want to be a liquidity provider, always. Just keep that in mind

Leo Valencia hosts the Gamma Optimizer options service at ElliottWaveTrader.net.