Six Penny Spread
Vol #127: April 27th, 2023
Down the street from me is a small co-op. They call themselves a co-op because they mostly sell organic produce and have a dozen different grains and cereals in bulk.
There are no mandatory work days, irate Facebook groups, or chaperoned trips home like the infamous Park Slope Co-Op. It’s part of a chain owned by one of the largest grocery stores here, which means they don’t lose $170k in an accounting mix up (embezzlement?) like the co-op near my old house in Chicago.
Broccoli omelettes for my daughter are getting more expensive every day with the oeuflation, but to the extent I’m paying attention to prices it’s their absolute level. I grumble about how much my springtime strawberry addiction costs, but I’ve never thought twice about the grocer’s margin.
In exchange for giving my phone number as an index to analyze one household’s purchases, I get an automatic 2% off. A few bucks here and there is pretty nice, and parting with a slice of personally identifiable information hopefully means they stay on top of their agave syrup stock. (For the margaritas.)
The grocery store is open for ten and a half hours every day of the week, and three and a half on Sunday. They keep their fruit fresh and workers paid (ahem, Dill Pickle of Logan Square). As they continue to provide that service, they deserve to earn a profit. I know they’re buying the apples cheaper from a nice old Norman family two hours north of here, but Bio Coop is offering them to me right down the block, next to clementines from Corisca and chickens from Bresse.
The capitalist reality is that banana margin probably ends up as dividends to a pension fund, but that abstraction keeps the economy going. I am more than happy to pay for the access and availability. For a natural grocery store, the average is somewhere around 5-10% “premium” over wholesale. Sign me up.
When traders pull up the markets, all they think about is negative edge. Neitzche must have been talking about the bid-ask spread when he suggested that the abyss also gazes into you. This gulf mocks both buyers and sellers, a chasm that drives the steadfast mad.
Even in relatively liquid markets where spreads are pennies wide, traders attempt to get cheeky with below market bids and elevated offers. Why not? Squeezing out a few extra cents translates to dollars per contract. If you’re executing frequently this truly does add up.
Market makers obsess about edge. Their business is making lots of trades buying slightly below estimated fair value and selling slightly above, hoping they've priced liquidity and volatility correctly. The edge they collect on a trade is an important value to track, because it is a direct representation of their confidence interval about valuation.
Grocery store owners should be keenly focused on the cost of transport, the price of wholesale pearl onions, and how much the store down the street is selling them for. Chefs should be more focused on how to make the best beef bourguignon possible, just as the vast majority of investors should be more focused on their objectives than the bid-ask spread.
When an investor comes to the market, their goal should not be to trade above or below fair value. Unless you’re a market maker, options should be used as a tool to achieve broader investment objectives. That could be something complex like taking a position on elevated skew, or it could be something simple like reducing portfolio volatility with protective puts or collars.
On an order by order basis the negative edge boogey man is distracting, but aggregated it becomes absurd. Last week there was an article published by Bloomberg suggesting that retail traders are losing $358,000 a day by trading 0 DTE options.
When you throw out a number on the order of the median American home price, it’s going to grab some attention. It’s worth digging a little bit deeper here though. The full study is available here.
First off the bat, $368,000 sounds big, but it’s a lot less when you consider the fact that just yesterday, 1.3 million contracts traded in SPX 0 DTE options. Since they were introduced in May of 2022, 0DTEs have averaged a little over a million contracts, or 42% of SPX volume. Retail traders account for about 6% of this overall volume. (The study only covers SPX, and the authors used a specific trade flag to identify retail traders.)
So on 6% of a million, or 60,000 contracts, they’re losing about $6 per contract. Six cents in options pricing terms, or the difference between paying $16.50 or $16.56. That’s roughly what an ATM option one day out costs in the SPX, and the markets are about .20 wide. So on average, retail is losing less than half of the bid ask spread in their trades. If you think about SPX as 10x SPY, it gets even better - it’s only six tenths of a penny there.
That’s phenomenal.
If the market was perfectly priced, there should be no net profits or loss. That would indicate that over the millions of different retail trades, an equal amount were wrong as were right. That’s a fair assumption, and the same one sophisticated market participants make. Trades tagged as retail are no more or less likely to be directionally correct. They’re desirable as counterparties because they’re small and random, not because they’re wrong.
However, the market doesn’t exist in a vacuum, and there are important frictions like transaction and liquidity costs. The exchange has to get paid for keeping the matching engines firing, and the liquidity provider has to get paid for delivering the other side of a trade across a thousand different strikes, on demand.
Regardless of what you think about when you look at the gaping bid-ask spread, the cost of liquidity is incredibly cheap. But not only is the actual per contract cost very little, the sample studied is actually biased towards order flow that should be expected to have an above average cost.
One of the most unique features of options market structure is the existence of price improvement auctions. This isn’t a feature that a retail or even institutional trader can opt into, it’s more something that happens in the sausage making between order and fill. Orderflow routed here is a relative, if not perfect proxy of retail volume.
Whether the order is coming from Ameriprise or Robinhood, if it’s smaller than 250 contracts there’s a good chance that it gets put through an auction. This mechanism lets wholesalers provide tighter liquidity to counterparties they know to be friendly. (More on payment for orderflow and the dynamics in Who, Who, Who, Who.)
These were only introduced in SPX in 2020, because despite being an industry volume king, it remains a single list product favored by institutions. In a bid to get retail more involved, a rule change was put through and voila, “SLIM” (single leg improvement mechanism) volume was parsed.
The only order that will go through an auction, is an order that has a matched contra side. This means that upon receiving that order, the dealer felt it had enough edge for them to take the other side and bring the paired order to the exchange. If the order wasn’t “taking liquidity” it would simply be routed to the CBOE to post in the order book. So by definition, any order that goes through SLIM is liquidity taking and should therefore expect to pay some premium for this immediacy.
How these options are being used and who is trading them is up for great debate. I’m not convinced that it’s the r/wallstreetbets army that’s been driving up the volumes on their own. There are plenty of sophisticated market participants that have reason to use them to manage intraday volatility swings and isolate nuanced greek exposures. Much of that volume could also be routed through an auction, further muddying the waters of who is doing what.
Market makers are the only ones that trade for edge’s sake. Everyone else has to find some other “edge” as to why they are making this transaction; be it research, statistics, or allocations. You’re not “giving away edge” by crossing the spread any more than you’re giving away margin to your butcher. To pay up $6 on a $1250 call purchase is less than half a basis point. How that trade fits into the rest of your portfolio is orders of magnitude more important.
Shiny new things are always bound to ruffle some feathers. Before it was the atrocious losses, it was an impending volmaggedon from these short term nukes. The real story here though, is just how deep and liquid options markets can be. If you’re looking to execute an options strategy, the time has never been better. Your brokerage can be free, there are literally millions of possible combinations, and the humble dealer is only charging a pittance. Take those two cents to the bank.