How Savvy Traders Approach Index Option Trades

Index options tend to have wide bid and ask spreads. Try to keep slippage low by making use of price discovery.

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Key Takeaways

  • When trading index options, consider limit orders
  • Use price discovery to place trades

Index options on the SPX, RUT, and NDX are the granddaddies of the option world. They’re high-priced, actively traded, and attract some of the biggest professional traders. You trade these options, and you’re playing in the big leagues. And they’re also a place where you can learn valuable lessons about trading mechanics and reducing slippage—knowledge that applies to anything you trade. Trading index options can be unforgiving. You learn from mistakes fast. The key to avoiding these mistakes is to think about index option trades like a savvy trader.

You’ve Got the Data

In addition to being big and popular, index options can have a downside: wide bid/ask spreads. For example, take a look at the NDX options on the Option Chain of the Trade page on the thinkorswim® platform from TD Ameritrade (your base camp for trading options). By default, the Option Chain always shows the option’s bid and ask prices. The bid is the price at which the market maker is ready to buy, and the ask is the price at which the market maker is ready to sell. But check out the 6700 calls in Figure 1. The bid is $235.60, and the ask is $240.60. That’s $5 wide, meaning that if you sold that 6700 call on the bid, and bought it on the ask, you’d lose $500. Not so good.

So, why are bid/ask prices of these options relatively wide? Two reasons. First, the volatility of the NASDAQ futures. NDX-option market makers hedge their options with /NQ futures, and the options’ bid and ask prices are “wrapped around” a fair theoretical value based on the /NQ price. Because the price of the /NQ futures can change quickly, a market maker who buys on the bid price or sells on the ask price may miss trading the /NQ future at a price that determined an option’s theoretical value. The market maker factors this possibility into the bid/ask, giving herself more “room” (buy on a lower bid, sell on a higher ask) in case she doesn’t get her futures executed at her target price.

Second, the NASDAQ options are big in dollar terms because the price of the NDX index itself is a big number. The average of the bid/ask price of that 6700 call is $238.10. With a $100 contract multiplier, that option is worth $23,810. Compared to that number, the $500 in between the bid/ask is about 2%, which is about the same as some of the most liquid equity or ETF options. So, yes—the bid/ask spread of the NDX options is wide in dollar terms, but not necessarily very wide in percentage terms.

FIGURE 1: WIDE BID/ASK SPREADS. Index options are big, powerful, and have wide spreads. Look at the bid and ask prices on the Option Chain from the Trade page of your thinkorswim platform. Source: thinkorswim from TD Ameritrade. For illustrative purposes only.

Careful, There’s Slippage

When you’re trading anything, you want to keep your slippage low. Slippage is the difference between your execution price and an option’s fair value. Let’s say the fair value of that 6700 call is $238.10 (the average of the bid/ask spread, or “mark,” is an estimate of fair value). If you sold that call at $235.35, you’d pay $275 in slippage. The savvy index trader tries to reduce that slippage by using limit orders, price discovery, and almost never using market orders.

Avoiding a market order is pretty clear, because a market order isn’t held to time or price. A market order can get filled at any price. And a market maker seeing a market order come in can take full advantage. The answer is to consider using limit orders when trading index options with wide bid/ask spreads. Just remember there is no guarantee your limit order will be filled, especially in fast-moving markets. But what limit price? This is where price discovery comes in.

What’s In a Price?

If bid and ask prices are where the market maker wants to trade, but those prices have too much slippage for you, price discovery is where you find the price at which you and the market maker can execute a trade. This minimizes your slippage, while still giving the market maker an incentive to trade.

To start, look at the bid/ask size of the option, also on the Option Chain. For that 6700 call, it’s 52 x 57, meaning there are traders willing to buy 52 calls for $235.60 and sell 57 calls at $240.60. If you want to sell five of those calls, for example, you can begin your price discovery by routing a limit order to sell one at just above fair value, maybe $238.15. If you sell it there, great. You just traded close to fair value and may want to offer the other four at $238.10 as well, because that seems to be the call price at which traders are willing to trade.

But say you offer that call at $238.10 and it’s not filled. The other 57 that were offered at $240.60 now join you on the offer, such that the bid is now $235.60 for 52, and the ask is now $238.10 for 58. Perhaps you’re getting closer to those traders’ preferred price. On the other hand, if no trader joins you at $238.10, you’re still on your own. In either case, you could consider canceling the first order, and maybe sending a new limit order to sell one at $238. Now: do you get filled at that price?  Are other traders joining? 

This is the price discovery process. You take your order to sell one call down $0.05, or $0.10, at a time, until you’re filled—hopefully above the bid price. At that point, you’ve discovered what the trading price is, and you can route your other four at that price with a good chance of getting filled.

This approach to price discovery give you a chance to reduce slippage when you trade high-priced options. Plus, you’re learning how traders think, and building incomparable trading muscle in one of the biggest arenas there is. And that can make you a savvy index trader.

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