When I'm buying an option, I notice that if I set a limit order for in between the ask and bid - say half way, I can often get the option at that price. Why is it that way? I thought the ask price was supposed to be the lowest that anybody was willing to sell it.
Sounds to me like you're describing just how it should work. Ask is at 30, Bid is at 20; you offer a new bid at 25. Either:
- A market maker fulfills your order
- A new entrant matches your offer
Depending on liquidity, one or the other may be more likely.
This Investorplace article on the subject describes what you're seeing, and recommends the strategy you're describing precisely.
Instead of a market order, take advantage of the fact that the options world truly is a marketplace — one where you can possibly get a better price just by asking. How does that work? If you use a limit order (instead of a market order) when opening a position, you can tell your broker how much you are willing to pay to enter a trade.
For example, if you enter a limit price of $1.15, you can see whether the market-maker will bite. You will be surprised at how many times you will get your price (i.e., $1.15) instead of the ask price of $1.30.
If your order at $1.15 is not filled after a few minutes, you can modify your order and pay the ask price by entering a market order or limit order at the ask price (that is, you can tell your broker to pay no more than $1.30).
There are people whose strategy revolves around putting orders at the bid and ask and making money off people who cross the spread. If you put an order in between the current bid/ask, people running that type of strategy will usually pick it off, viewing it as a discount to the orders that they already have on the bid/ask. Often these people are trading by computer, so your limit order may get hit so quickly that it appears instantaneous to you. In reality, you were probably hit by a limit order placed specifically to fill against yours.
There are usually so many different options around for the same stock that some are rarely traded. Especially if the price has moved since the option was issued, nobody might be interested in that particular option at that price anymore. So the asking price might be something that someone asked for ages ago and that is much higher than anyone would reasonably pay today.
With a bid of $20 and an ask of $30, nobody is trading, but the value of that option is somewhere between $20 and $30. If the value is below $25, someone will notice your $25 bid and sell.
I can often get the option at [a] price [between bid and ask]
The keyword you use here is quite relevant: often. More realistically, it's going to be sometimes.
And that's just how supply and demand should work.
The ask is where you know you can buy right away. If you don't wanna buy at ask, you can try and put a higher bid but you can only hope someone will take it before the price moves. If prices are moving up fast, you will have missed a chance if you gambled mid-spread.
Having said that, the larger the spread is, the more you should work with limits mid-spread. You don't want to just take ask or bid with illiquid options. Make a calculation of the true value of the option (i.e. using the Black Scholes Model), then set your bid around there. Of course, if not only the option but also the underlying is illiquid, this all gets even more difficult.
What you have to remember is that Options are derivatives of another asset like stocks for example.
The price of the Option is derived from the price of the underlying. If the underlying is a stock for example, as the price of the stock moves up and down during the trading day, so will the Market Maker's fair value for the Option.
As Options are usually less liquid than the underlying stock, Market Makers are usually more active in 'Providing a Market' with Options. Thus if you place a limit order half way between the current Bid and Ask and the underlying stock price moves towards your limit order, the Market Maker will do their job and 'Provide a Market' at that price, thus executing your order.
1. To provide room for variation in the price of the underlying
Option prices vary based on the price of the underlying stock.
As a result, if the price of the underlying stock moves, the market maker posting option prices in the market has to adjust the price of his quotes to respond. It can take some time to update each one, so often the market maker prices in a little 'buffer' so that his quotes are still valid if the market moves a little bit.
As a result these same market makers may 'hit' bids or offers at more competitive prices.
2. Willingness of market participant to buy options at the displayed price.
If people are willing to buy at the displayed price anyway, why improve upon it?
3. Payment for order flow
One practice that continues to this day is "payment for order flow" (sometimes called "customer priority"). A market maker can make an arrangement with a broker or an "order flow provider" (someone who aggregates orders from brokers) to have them 'direct' the order to them in exchange for paying the order flow provider a fee. This fee allows them to gain market share without having to compete on price.
4. Penny Pricing
Most US stock options are priced in nickel ($0.05) increments. However a few exchanges (BATS Options and NASAQ Options) operate order books that allow options to be priced in penny increments. Those prices are not published on the market data feeds. There has been some resistance against this (penny pricing limits how much money can be paid to an order flow provider). Incidentally, these exchanges do not operate payment-for-order flow schemes.