Cboe Global Markets

Order Types and Off-Screen Liquidity: What You See Isn't Always What You Get

May 14, 2021

As an experienced trader, you often start a trade by checking the three measures of liquidity—volume, open interest and the bid/ask spread. If there are enough buyers and sellers, you assume the market is liquid enough to trade. If not, you might have trouble getting in or out of positions easily and efficiently, so you stay away.

But there’s just one catch when making a liquidity assessment: There are often more market participants—market makers and other traders—in the room than appear on your trading screen. In short, there may be “off-screen liquidity” invisible to your platform’s digital eye. And as most professional traders know, if a given instrument is a compelling trade, then you have to seek out that liquidity by finessing your orders.

Such is the case with emerging instruments like the Mini-S&P 500 Index (Mini-SPX, ticker XSP) and Mini-Russell 2000 Index (Mini-RUT, ticker MRUT) options.

Why Trade Mini-SPX and Mini-RUT Options?

Investors and traders have gravitated to these relatively new products for their attractive benefits:

  • Smaller notional value. At 1/10th the size of standard index options (which have a contract multiplier of 100), mini index options reduce both the cost and the exposure to the underlying index. This may be ideal for investors who are new at trading options and want to avoid carrying the full risk, traders with a smaller account size, and hedgers who want to fine-tune their hedge, especially if hedging a portfolio smaller than 100 times the SPX index value.
  • Cash settlement and expiration certainty. Mini-SPX and Mini-RUT options feature European-style expiration, thereby eliminating early exercise risk. Another benefit of European expiration is there’s no “dividend risk.” Plus, mini index option values are derived from the S&P 500 Index itself and not on an exchange-traded fund; at expiration in-the-money options are settled to cash rather than delivery of shares. (Learn more about the risks of minis versus ETF options.)
  • Tax efficiency. Mini-SPX and Mini-RUT options may be easier on investors at tax time, as the contracts are eligible for a 60% long-term and 40% short-term capital gains split. The larger your realized gains, the greater your tax savings.

These benefits may seem attractive to many investors, but what about liquidity? Sometimes a new product has less displayed liquidity (i.e., not as tight a bid/ask spread) than a more established one. 

But what you see on your trading screen isn’t always what you’ll get. And in the case of liquidity that can be a good thing. Sometimes liquidity is there but it’s non-displayed. Here's how to hunt for it.

The Cardinal Rule of Hunting for Off-Screen Liquidity

If you’re looking for off-screen liquidity in any market, be careful when using market orders.

The Market Order: “I Want In (or Out) NOW”

A market order is the most basic type of order—the plainest vanilla in the order-type display case. A market order says, “I’ll take whatever best bid or ask is available right now because I want in (or out) now.”

When you place a market order, you understand you’re not aiming for entry or exit at an ideal price, but the best possible price that buyers or sellers are offering.

Example: You’re looking to buy a call option where the displayed asking price is 90 cents. If you accept it, your order will immediately be executed, typically at 90 cents—but that's not guaranteed. The actual fill price depends on market conditions.

Market Orders Can Result in “Slippage”

When you place a market order, you might experience slippage, which is the difference between the price you wanted and the unfavorable price you actually received. That’s the informal definition.

Let’s take a closer look at what’s actually happening.

Imagine a line of buyers and sellers. The sellers at the front of the line are willing to sell contracts for 90 cents. Further back, sellers are asking progressively higher prices, say up to 93 cents. The buyers first in line are likely to get in at the 90 cent price. The buyers in the middle or back of the line will likely be matched with sellers at the higher prices. This image, though not perfect, illustrates how slippage happens when you place a market order. It depends on how far back in the line you stand among all other investors who want to buy the same contract at the same time.

Plus, liquidity in today's electronic marketplace is made up of traders and investors, but also market makers bidding and offering competitively, across several exchanges, faster than the blink of an eye. These ultra-fast algorithms help keep markets fair, competitive, and efficient, but it sometimes means the market can vary a bit between when you click the order button and when a trade gets entered into the trade-matching engine.

You may or may not have gotten in at 90 cents. Maybe you got in a penny or two higher, but that’s beside the point. You wanted your trade executed immediately, and you got it.

The Limit Order: “I Want In (or Out) at This Price or BETTER”

A limit order allows you to define a specific price as your absolute limit. It essentially says, “Give it to me at this price or better.”

Think of the saying “buy low, sell high.” Following this logic, the “or better” price for a buyer is lower, and it’s higher for a seller.

Example: Let’s suppose you approached the previous scenario with a limit order instead of a market order. You want in at 90 cents or better. If you placed your limit order at 90 cents, then you may be filled at 90 cents or lower, which is better for a buyer. The caveat here is that your order may not get filled if you’re bidding too low (or asking too high, if you’re a seller).

What does this have to do with hunting for off-screen liquidity versus taking what’s asked for or offered? Good thing you asked.

Finessing the Trade as a Buyer or Seller

Let’s suppose you want to go “long” a Mini-SPX call option, and the “displayed liquidity” isn’t what you had hoped. Volume and open interest are somewhat low, and the option has a bid of 0.80 and an offer of 0.90—10 cents wide.

The bid at 0.80 isn’t moving. Is nobody really willing to sell at that price? Must you buy at 0.90 or higher by placing a market order? Aren’t there people willing to negotiate between the bid and the ask?

The answer is yes, or at least, quite possibly. The bargaining’s likely taking place; it’s just not displayed.

So, where does the price reside in between the screens? Just like when traders bring a large order to the floor for negotiation, this can be done electronically. Buyers and seller can persist in a bid or offer on-screen until they are matched.

If the bid at 0.80 isn’t moving but you feel 0.90 is too high, then target some price in the middle (but nudged a little toward the offer), like 0.86, as a limit order. You might begin with a lower starting bid, working your way up to 0.90. This way, you’ll be able to find out if a seller is lurking in the in-between space to sell you a contract.

Again, you’ll want to use a limit order to help you uncover some off-screen liquidity. And when you’re ready to close out that position, you might also choose to use a limit order, with an asking price somewhere between the displayed bid and offer.

After all, market makers and other liquidity providers are in the business of seeking small deviations from the theoretical value of an option. They compete with each other—often fiercely—and spread their risk across multiple venues. If they see a penny or two of edge, you're likely to find a taker between the displayed bid/ask. 

The Bottom Line

If you find that the benefits of mini index options match your investment strategy and risk tolerance, don’t let the apparent illiquidity dissuade you from trading. If you like the value proposition—smaller contract size, cash settlement, tax and capital efficiency, sidestepping early exercise risk, and dividend risk—that these products offer, don't rule them out. Work a bit to find that hidden liquidity. There may be more to it than meets the eye, but you have to find it.

*Under section 1256 of the Tax Code, profit and loss on transactions in certain exchange-traded options, including XSP and MRUT, are entitled to be taxed at a rate equal to 60% long-term and 40% short-term capital gain or loss, provided that the investor involved and the strategy employed satisfy the criteria of the Tax Code. Investors should consult with their tax advisors to determine how the profit and loss on any particular option strategy will be taxed. Tax laws and regulations change from time to time and may be subject to varying interpretations.

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of “Characteristics and Risks of Standardized Options.” Copies are available from your broker or from The Options Clearing Corporation at 125 South Franklin Street, Suite 1200, Chicago, IL 60606 or at www.theocc.com.

Past performance is not indicative of futures results. The information in this article is provided for general education and information purposes only. No statement(s) within this article should be construed as a recommendation to buy or sell a security or to provide investment advice. Supporting documentation for any claims, comparisons, statistics or other technical data in this article is available by contacting Cboe Global Markets at cboe.com/contact.

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