To Buy or to Sell?Ever look at a stock and think it was really cheap? Maybe that blue chip stock is trading at multi-year lows, or a solid stock took a recent dive, or maybe a stock looks attractive because it pays a big dividend. Perhaps you applied the rules of your favorite model or strategy and concluded the stock is a buy.
Remember, for every buyer there's a seller. No matter how good or bad a stock looks, there's got to be someone else taking the other side of the trade. If the stock really is cheap, those who recognized this cheapness would buy the stock and drive up the price. Soon others would perceive the stock as expensive and sell the stock. Ultimately, the stock price would reach a point where the supply meets the demand. This happens constantly throughout the trading day, and the current stock price represents the balance between buyers and sellers of a stock in the market.
In the stock market, the price at which sellers are willing to sell and buyers are willing to buy are posted as the bid and ask price. When the bid and ask are quoted, a size is also quoted. A bid of $10 with a size of 600 means someone is willing to buy 600 shares of a stock at $10. If you wish to sell more than 600 shares, you may have to look down the queue of buyers and sell some of your shares at the next bid price.
Options Trade to a Different TuneIn the options market, the price of the option is derived from the price of the stock, hence the term derivative. The price of an option changes in response to changes in the underlying stock price, and not necessarily as a result of actual trading activity in the option. Bid and ask prices are often quoted without any real buyer or seller in the market. How are these price derived, and how does your order get filled when no orders exist on the other side of your order?
On the option exchanges, there is a company or individual, termed the specialist, responsible for guaranteeing a market in the security you want to trade. In the absence of buyers and sellers, the specialist prices options using variations of option pricing models, such as Black Scholes, and must fill a minimum number of contracts at the posted prices.
Imagine you are a specialist for options on a stock. Many call buyers enter the market but no call sellers. You are obligated to fill the orders of the call buyers, regardless of the fact there are no sellers. The specialist assumes liability by filling these orders, since a rise in the stock price will cause the specialist, who is short calls, to lose money. Specialists are interested in making money on the turn, and are limited in the amount of risk they can take. As a result, the specialist must offload the liability from selling the calls either by finding other market makers to fill some of the orders, or by buying the stock. If the specialist buys the stock there is the risk of the stock falling, and puts must be purchased to maintain complete protection from changes in the stock price. In practice, there are sophisticated algorithms which combine long or short stock positions with different option positions to provide the best hedge.
The specialist may also respond to a large inflow of call orders by raising the price of the option contract. This will discourage call buying and entice other potential call sellers to step into the market and assume some of the liability of filling the buy orders.
That's where the individual option trader comes in. When the specialist raises the call price, an individual trader can step in and sell options at the higher price, effectively offloading some of the liability of the specialist.
One of the most attractive features of stock and option trading is that an individual trader can take either side of any trade. If the option looks cheap, buy it. If it looks expensive, sell it. Just be aware there is someone else on the other side of your trade who is betting the stock will go in the other direction.