No more option trading for me.

[clifp]

Over the last decade I've average between 50 and 150 trades a year. About 30ish are equity (include no commission ETFs) and the balance options.

My working theory is that writing puts or calls reduces portfolio volatility with minimal loss of performance. It was gratifying meeting with a sharp Schwab portfolio manager with $300 million in asset espouse the same philosophy. But after reading Micheal Lewis book I am done, the front runner have killed all my hope of making money writing options.

My understanding of what is going is as follows, but it is complicated and there is a decent chance I wrong, so I am very open for discussion.

Options trading circa 2002-2005
Say I owned 1,000 shares of XYZ that wanted to write a cover call.
I'd use the Schwab Trading platform Street Smart Edge which provides level 2 quotes so I could see the bid and ask size.
My screen would look something like this for slightly out of the money call call with S&P200 company.

Bid 5@$1.00, 10@$1.00, 10@$1.00 50@$.95

Ask 10@$1.10, 100@$1.10, 50@1.10 5@$1.15
I'd look at that see there was more selling volume than buying volume so I'd submit a limit order for selling 10 calls @$1.05.

Now maybe another person would drop their price to $1.05, but I didn't really care since I was the first one at the price my order would be executed first.

If on the other hand the bid and ask volumes were reversed. I'd probably set my price at $1.10 in hope that the guys wanting to buy 50 or 100 would take everything.

While I did do some calculations since I am only making 2-10 trades month, I wasn't super analytical. Sometimes I get the order other days I wouldn't.
Still I would try and save a $.05 at 10 contract it was $50 and if save a nickel 20 times a year that was a $1,000

But for past few years I notice a change in option trading. Even though daily volume has increase modestly, the number of contracts for sale or bid on has increase several times. I also notice that a soon as I entered $1.05 instantly a bunch of other contracts were being offered $1.05.

Now I naively thought being the first person to offer to sale a call at $1.05 I'd be the first one to do a trade at the price. After I reading the book, I now understand that because they front run my order. I'm no longer the first person on most exchanges cause of the fast connections. I also noticed the most of the time when option order is filled the first order is for 1 contract.

I now understand that when someone puts in a order to buy 100 contracts at $1.05 (which they are enticed to do by false ask orders). What happens is they buy my 10 contract and 1 HFT contract. But all of the other ask order disappear.

The buyer only has got 11 of the contracts he wanted so the HFT guys will offer him the remaining contracts at $1.10 or maybe even higher. Their computer will now know there is real buyer who actually wants to own call options for more than a few milliseconds.

If on the other hand the order is for only 10 contracts, the HFT trader will jump in line and sell the contracts $1.05 and then immediately offer to buy them at $1.001 (yes a 1/10 of cent)

As it it option trading is zero sum game. But it seems like a negative game now. If I lose anywhere from $.01 to $.05 per contract because of front running another per cent or two because of commission.. and say write a covered call each quarter it seems to me I am start 8% to 25% in the hole...

I'll start again but only with a less slanted playing field.

 

[Fishingmn]

60 Minutes just did a story on this topic last Sunday - pretty interesting if you haven't seen it. All of the big mutual funds & brokerages finally caught on and are coming up with ways to fight it but either the government or exchanges need to step in to change it. Some people are making a crapload of money right on it though.

 

[Fermion]

Options are a tricky thing.

If you have a stock that is thinly traded, you can get situations where you can't sell an option even though it is priced lower than the stock.

I mean I have had a $10 stock and an option to buy it for $9 and I could not sell the option for $0.95. Rare but seems to happen.

I probably will still occasionally write covered calls (or more likely buy-writes, which is one of my favorite low risk ways of getting into a dividend paying stock). One advantage of buy-write is you are not limited to $0.05 increments but can use $0.01 and get the order filled.

 

[BTravlin]

Sounds like you're playing against the house in Vegas to me. I'd wrap it up too under those circumstances.

 

[aja8888]

Interesting. Yesterday on CNBC Fast Money Halftime show they interviewed a CEO of a HFT company (actually had him on the show). He denied anything and said they were doing all legal stuff (creating their own market?) and that the exchanges need to change their software, etc. A floor trader on the show was furious when commenting on this persons denials.

 

[clifp]

60 Minutes just did a story on this topic last Sunday - pretty interesting if you haven't seen it. All of the big mutual funds & brokerages finally caught on and are coming up with ways to fight it but either the government or exchanges need to step in to change it. Some people are making a crapload of money right on it though.

Yes I saw the 60 Minutes piece, which prompted me to buy and finish the book. After I finish the book, I realized any typed of even moderately frequent trading (4 times a year) is really because of front running even if spreads are $.01

 

[Fermion]

Yes I saw the 60 Minutes piece, which prompted me to buy and finish the book. After I finish the book, I realized any typed of even moderately frequent trading (4 times a year) is really because of front running even if spreads are $.01

I guess the problem here is your frequency of trading. I am writing calls that expire in Jan 2016 that are 20% out of the money. If I can get $2 for the call on a $30 dividend paying stock, then I don't care a great deal if I missed out on $2.01. Let the HFT guys fight over the penny every 2 years if it makes them feel better.

 

[45th Birthday]

I guess the problem here is your frequency of trading. I am writing calls that expire in Jan 2016 that are 20% out of the money. If I can get $2 for the call on a $30 dividend paying stock, then I don't care a great deal if I missed out on $2.01. Let the HFT guys fight over the penny every 2 years if it makes them feel better.

I totally agree with this statement. I use various option strategies that add 2.5-3% return to my portfolio each year whether the market goes up or down, with an acceptable level of risk. It takes a lot of work, and I notice some funky stuff going on. However, I only place orders at prices I want. Things change quickly, and if someone gets a different price, I'm not really bothered.

 

[Fermion]

I totally agree with this statement. I use various option strategies that add 2.5-3% return to my portfolio each year whether the market goes up or down, with an acceptable level of risk. It takes a lot of work, and I notice some funky stuff going on. However, I only place orders at prices I want. Things change quickly, and if someone gets a different price, I'm not really bothered.

When the market starts feeling a little tippy, a covered call is such a nice way to take a little bit off the table without paying any tax. We retire in 2015 and a 2016 call will not generate any tax until 2016 unless of course your shares are called away early...which means you made 30+% in less than 2 years. That is a problem I can handle.

 

[brewer12345]

S&P200 company.

That is your problem right there. With anything liquid there has not been money to be made for years playing games like this. Don't waste your time racing your Yugo against the big boys with their Ferraris. If you wish to play this sort of game, find much less liquid stuff where they are not around and commence trading. One of my buddies once blew up an options desk for a small cap by putting on such a big position that the fool running the desk could not hedge the trade he stood up to. Its fun!

 

[marko]

The 60 minutes piece is not new news. A while ago, I think it was Wired had an article about people who actually moved their servers/offices closer to NYC in order to cut an extra billionth of a second off the transit time.

As a few have noted, if someone makes an extra penny off my trade it's not going to stop me from long term investing.

I found the 60 minutes piece to be disingenuous in that, while accurate, only scared the mom and pop investor away and confirmed their fears that "the market is rigged" against them.

Yeah, better to keep that money under the mattress.

 

[Fermion]

Also if HFT becomes too lucrative, more people will jump into HFT. Pretty soon someone will jump ahead of the other and try to steal your trade for only half the profit then someone will jump into this business and be content with a quarter of the profit.

 

[ERD50]

That is your problem right there. With anything liquid there has not been money to be made for years playing games like this. ...

But don't issues with lower liquidity also have some pretty high bid-ask spreads? It always seemed to me I'm better off with the 1 or 2 penny spreads, and a possible penny to the HFT on liquid issues, than I am with the 5-10 cent spreads I seem to see on less traded issues.

-ERD50

 

[brewer12345]

But don't issues with lower liquidity also have some pretty high bid-ask spreads? It always seemed to me I'm better off with the 1 or 2 penny spreads, and a possible penny to the HFT on liquid issues, than I am with the 5-10 cent spreads I seem to see on less traded issues.

-ERD50

Depends on your goals. Iwrote yet another round of 3 month calls on nm for a buck this morning. I don't care about the spread because I will let them expire. But there likely nobody but me and the options desk trading the contracts.

 

[45th Birthday]

When the market starts feeling a little tippy, a covered call is such a nice way to take a little bit off the table without paying any tax. We retire in 2015 and a 2016 call will not generate any tax until 2016 unless of course your shares are called away early...which means you made 30+% in less than 2 years. That is a problem I can handle.

Agree again. If you write in-the-money calls, the tax rules get complicated pretty quickly. I avoid doing this for that reason; others might we willing to deal with the complexity. It sounds like yours are pretty far out both in strike price and time.

 

[clifp]

Depends on your goals. Iwrote yet another round of 3 month calls on nm for a buck this morning. I don't care about the spread because I will let them expire. But there likely nobody but me and the options desk trading the contracts.

I am not sure you are right about that. The HFT have standing orders for practically all the stocks in the market, the Wilshire 5000, not just S&P.

I written options on stocks like O, and AEP, which have similar option liquidity to NM daily volume 0-100 contracts with average around 20 and open interest around ~1000 contracts, with a typical spread of $.10 on $1 option.

I realize now that I have been front run everytime I've tried to narrow the spread. Now maybe they haven't done NM yet but I'd test it.

My guess is the have buy and sell orders out for every stock and every strike price. They aren't risking anything making the offers. Worse case they are force to buy or sell one contract. But by front running me they can generally steal the $.05 I use to make by trying to narrow the spread.
Sure you can write a limit order accepting the bid price but that seems sup-optimal with a $.10 spread.

 

[brewer12345]

I am not sure you are right about that. The HFT have standing orders for practically all the stocks in the market, the Wilshire 5000, not just S&P.

I written options on stocks like O, and AEP, which have similar option liquidity to NM daily volume 0-100 contracts with average around 20 and open interest around ~1000 contracts, with a typical spread of $.10 on $1 option.

I realize now that I have been front run everytime I've tried to narrow the spread. Now maybe they haven't done NM yet but I'd test it.

My guess is the have buy and sell orders out for every stock and every strike price. They aren't risking anything making the offers. Worse case they are force to buy or sell one contract. But by front running me they can generally steal the $.05 I use to make by trying to narrow the spread.
Sure you can write a limit order accepting the bid price but that seems sup-optimal with a $.10 spread.

I usually trade options very sparingly. When I trade, I usually try to get between the bid and the ask and wait for a bid. Much of the time I get hit, it is clearly because the stock fluctuated and the bid or the ask moved in the direction necessary for my limit order to execute. Would this work if I were trying to be a slickster and make a trade where 5 or 10 cents made much of a difference? Probably not. I acknowledge that I am a retailer and handicapped as such. I only trade options and junk bonds when it is "hit the side of the barn" attractive to do so, since I expect to get skinned transactionally. So when a covered call on something I am happy to sell offers a 40% annualized yield (as was the case with NM this morning), I will make the trade and ignore the excessive frictional costs. When I can buy a junk bond I think is money good at 60 cents or less of the dollar I will do it and ignore the 3 to 5 points of bid-ask spread.

 

[clifp]

I usually trade options very sparingly. When I trade, I usually try to get between the bid and the ask and wait for a bid. Much of the time I get hit, it is clearly because the stock fluctuated and the bid or the ask moved in the direction necessary for my limit order to execute. Would this work if I were trying to be a slickster and make a trade where 5 or 10 cents made much of a difference? Probably not. I acknowledge that I am a retailer and handicapped as such. I only trade options and junk bonds when it is "hit the side of the barn" attractive to do so, since I expect to get skinned transactionally. So when a covered call on something I am happy to sell offers a 40% annualized yield (as was the case with NM this morning), I will make the trade and ignore the excessive frictional costs. When I can buy a junk bond I think is money good at 60 cents or less of the dollar I will do it and ignore the 3 to 5 points of bid-ask spread.

I understand and the same thing is true for a few of my testosterone trades like writing Tesla puts last year. I was getting 40% annualized so the $.05 didn't matter on a $5 put. But I was taking a serious financial risk, the stock could drop from my $150 strike price to $20 if Elon drops dead, or passing near some new microwave tower cause the lithium-Ion batteries to explode.

But most of my portfolio is boring stocks O, KMP, UPS, MMM, and the normal suspects of dividend stocks. So the purpose of writing calls is get mid double digit returns if they get called and high single digits returns if the stock stays flat and a few percent of downside protection if it drops.
I give up the 25-30% if we have another 2013. It ain't 2009 where the blue light special sign was flashing BUY ME NOW, I know you know about shipping stocks and I know I don't. But I do know it is volatile and it wouldn't be the first time the stock went from $10 to $5 or to $20 in 3 months. I don't see any $.60 junk bonds or riskless 40% annualized premium option opportunities.

But it use be only a few years ago, that the bid was $.90 and the ask was a $1.00 and you took the risk of say hey I'm will to accept the consequence of selling you a call option for $.95 if you guessed right sold the option and then stock dropped a bit, you made the trade of the day. With front running, you are taking the risk, but the HFT guys are getting the reward. So I am no longer playing their game.

 

[brewer12345]

I don't see many opportunities that are worth taking the bid-ask beating for. These days they are few and far between, so I sit on my hands. As for the shipping stocks, I have blow out most of my NM. The calls I wrote are on a lot of shares I was planning on selling anyway.

 

[explanade]

Yeah CNBC was issuing a spirited defense, like if you want to buy 100 shares of GE, HFT isn't affecting you.

Except that if your retirement funds are being skimmed out of a few cents each trade, then you are paying a cost.

Or when HTF leads to flash crashes, you are definitely being hurt.

Michael Lewis was on NPR Fresh Air and one thing that was astonishing is that flash crashes are more common than you think. Not the ones that move the market hundreds of points in a day up and down. But apparently individual stocks rise and drop for no fathomable reason and Lewis blames HFT.

The pro HFT people say it helps price discovery. Lewis says HFT are middlemen -- some might not use such a charitable word -- who really provide nothing to the economy, just money skimmed from other people's transactions.

His larger point is that you really don't need brokers any more. Back in the 19th and most of the 20th century, you did have to have brokers and banks to trade/invest in equities.

The Internet has provided the opportunity to disinter mediate the transactions, like it has in so many other arenas. But Wall Street has to find other ways to make money so it "innovates" with things like CDOs and other exotic instruments and practices.

Yet, turns out a lot of the leaders in Wall Street know very little about HTF, Lewis found. Certainly little about the physics and the technology involved. So he tells the story of a Canadian banker who discovered what HTF was doing and ended up creating an exchange which will send orders to other exchanges simultaneously, so that there's no room for HTF. Lewis says the interesting thing is, the people involved in this attempt to level the playground, are all immigrants, not the old money Wall Street.

 

[thedaily]

I guess the problem here is your frequency of trading. I am writing calls that expire in Jan 2016 that are 20% out of the money. If I can get $2 for the call on a $30 dividend paying stock, then I don't care a great deal if I missed out on $2.01. Let the HFT guys fight over the penny every 2 years if it makes them feel better.

How to you handle your downside risk? You'll have to hold onto the stock until 2016. I guess you could pull the plug and buy the calls back and sell your shares but since 2016 is far off will sharp drops of say a buck or so cause the long term call to drop significantly.

 

[clifp]

So I conducted an experiment today. About 5 minutes before the market closed.
I checked on the NM June 10 calls the same one Brewer sold earlier.

The bid price was $.60 there were more than 1500 bids at the price, the CBOE exchange alone had more the 400 contracts

The ask price was $.70 there were more the 2500 contracts at the price, CBOE had 600+ contracts available.

I entered an order to sell 5 contracts at .65. Instantly there were 2500 contracts available at $.65. I immediately cancel the order all the ask remained at $.65.

Now mind you this is for contract which did zero volume today. The open interest on the contract was 6800 and it is by far the most active NM option with typical volume about 20 or 30 contracts,and with 3 spikes of 1K+ volume in the last month. The average volume of the stock is 750K/day and there are 100 million shares outstanding.

Imagine somebody trying to buy 1000 or even 100 contracts could reasonably conclude that he could buy the options at $.65 today and based on history someday he could have. However, today there was no actual liquidity, just HFT creating the illusion of liquidity. Somebody entering a order to buy 1000 contracts at $.65 would have been lucky to get 10 at the price. If the person was foolish enough to make a market order, who knows what price he'd pay. $1.50, $2,3?.

Of course this behavior isn't just extend to options. I've ended up buying 1 share for $3 , when I was trying to buy 2000 shares of microcap that I've followed for years. I was pissed cause the $9 commissions were more than stock. Last May American Electric Power (a dull utility I own) fell from $50 to $22 in less than a minute. The NYSE erased the trade in the high low calculations, but some poor guy (who probably had a stop loss entered) sold his $50 stock to some HFF firm for $22. The NYSE didn't reverse the trade.

 

[FIRE'd@51]

So I conducted an experiment today. About 5 minutes before the market closed.
I checked on the NM June 10 calls the same one Brewer sold earlier.

The bid price was $.60 there were more than 1500 bids at the price, the CBOE exchange alone had more the 400 contracts

The ask price was $.70 there were more the 2500 contracts at the price, CBOE had 600+ contracts available.

I entered an order to sell 5 contracts at .65. Instantly there were 2500 contracts available at $.65. I immediately cancel the order all the ask remained at $.65.

I assume you monitored the stock price while this was happening to eliminate any delta-effect. I estimate the delta of the option was about 0.4, so a 0.10 move in the stock price should move the option price by 0.04.

You probably wouldn't want to do this, but it would be interesting to see, if you cancelled your sell offer and immediately put in a bid to buy 5 contracts at 0.65 if you would get immediately filled.

 

[clifp]

I assume you monitored the stock price while this was happening to eliminate any delta-effect. I estimate the delta of the option was about 0.4, so a 0.10 move in the stock price should move the option price by 0.04.

You probably wouldn't want to do this, but it would be interesting to see, if you cancelled your sell offer and immediately put in a bid to buy 5 contracts at 0.65 if you would get immediately filled.

The stock moved a penny from 9.20 to 9.19, since the order was valid for no more than a minute. I imagine 5 would filled because HTF firms have a 1 contract/100 share order at the fastest exchange (BATS) so probably there are 5-10 single contract order (1 per HTF firm). They have to wait for the order to hit the first exchange before they can front run. I know I have a had a lot of 10 contract order filled with 1,1,1,1,5,1 made in rapid session. It was more tempting to put in an order for 100 and see how many contracts I got.

BTW, these were exactly the type of experiments that Brad Katsuyama crew at Royal Bank of Canada did. But then RBC was allowing them to losing $10,000 a day, and it would be own money.

 

[Fermion]

How to you handle your downside risk? You'll have to hold onto the stock until 2016. I guess you could pull the plug and buy the calls back and sell your shares but since 2016 is far off will sharp drops of say a buck or so cause the long term call to drop significantly.

What downside risk? You mean the same risk that every other buy and hold investor that does not sell calls faces?

The biggest downside risk is that the market shoots up and I make 30% but have to pay short term capital gains.

I was selling calls on an index btw.