WIDE bid-ask spreads on ITM options

[Trader13]

A question for current and former options market-makers (MM): Why such wide bid-ask spreads on ITM options? For example, let's say two strikes in-the-money with two months until expiration. For stocks under $50, I've noticed spreads tend to be 15 to 20 cents, and 20 cents and higher for stocks between $50 and $100.

With penny spreads on the underlying stocks, I would think that MMs could immediately hedge with stock to offset their ITM option position, and handle this transaction very efficiently without demanding a large spread on the option. In this case, low volume and low open interest on the ITM option should not matter much, since they are hedging with stock and relying on the liquidity of the underlying.

Do MMs hedge with stock BEFORE they accept your option order (so they know with certainty that they can acquire the stock), or do they hedge after they process your option trade?

Could the high delta on the ITM option create a risk for the MM that the underlying will make a really fast move before they hedge? Is this risk the reason for the wide bid-ask spread?

Any insights appreciated. I'm just speculating! (bad pun)

 

[murray t turtle]

Quote from Trader13:

A question for current and former options market-makers (MM): Why such wide bid-ask spreads on ITM options? For example, let's say two strikes in-the-money with two months until expiration. For stocks under $50, I've noticed spreads tend to be 15 to 20 cents, and 20 cents and higher for stocks between $50 and $100.

With penny spreads on the underlying stocks, I would think that MMs could immediately hedge with stock to offset their ITM option position, and handle this transaction very efficiently without demanding a large spread on the option. In this case, low volume and low open interest on the ITM option should not matter much, since they are hedging with stock and relying on the liquidity of the underlying.

Do MMs hedge with stock BEFORE they accept your option order (so they know with certainty that they can acquire the stock), or do they hedge after they process your option trade?

Could the high delta on the ITM option create a risk for the MM that the underlying will make a really fast move before they hedge? Is this risk the reason for the wide bid-ask spread?

Any insights appreciated. I'm just speculating! (bad pun)

==============
Trader13;
Spread is based on option premium/stock vol more so than stock price;
and its almost always true in any business,
for sure in any option,low or medium volume = higher processing cost

Spreads have come down ''lots'' over the years

 

[Pabst]

Quote from Trader13:

A question for current and former options market-makers (MM): Why such wide bid-ask spreads on ITM options? For example, let's say two strikes in-the-money with two months until expiration. For stocks under $50, I've noticed spreads tend to be 15 to 20 cents, and 20 cents and higher for stocks between $50 and $100.

With penny spreads on the underlying stocks, I would think that MMs could immediately hedge with stock to offset their ITM option position, and handle this transaction very efficiently without demanding a large spread on the option. In this case, low volume and low open interest on the ITM option should not matter much, since they are hedging with stock and relying on the liquidity of the underlying.

Do MMs hedge with stock BEFORE they accept your option order (so they know with certainty that they can acquire the stock), or do they hedge after they process your option trade?

Could the high delta on the ITM option create a risk for the MM that the underlying will make a really fast move before they hedge? Is this risk the reason for the wide bid-ask spread?

Any insights appreciated. I'm just speculating! (bad pun)

Couple of reasons. Unless the stock IS liquid, there's substantial risk on an ITM hedge. One hundred contracts is 10,000 shares of stock. Obviously no prob in MSFT, but could be an issue, even with a dime edge, in something that whips. I've traded a bit of OIH lately and the options can suck, but then again the ETF spreads out 6 cents wide all the time.

Secondly: ITM's don't trade much. Thus, a lot of the MM activity is bots. Not much incentive for a real live trader to sit there changing markets all day so he can trade 15 cars during an entire session. The auto quote programs are generally set to be 20 wide in an illiquid stock, or even in a big name cap, if more than a couple of months out. Also keep in mind, higher priced options (over $3.00) have a minimum fluctuation of a dime.

The hedging is done AFTER the options trade, and more and more, by a bot as well.

 

[loufah]

Quote from Pabst:

ITM's don't trade much. Thus, a lot of the MM activity is bots. Not much incentive for a real live trader to sit there changing markets all day so he can trade 15 cars during an entire session.

Does an alarm sound at the MM's station when an inactive option series starts getting activity, to wake someone up? I was the first to buy OVRL Nov 10 puts on Friday, and as soon as I got filled, the price on the Nov's jumped, and soon after that the price on the Sep's jumped even more, and what had been a .30 difference between corresponding options in those months soon went down to .10. This was all after the underlying had done its high-volume pop; it was working its way down at lower volume. It's as if the MM woke up and said, "Hey, maybe I need to increase the IV here."