This is a great little tip for all option investors -- especially those who trade smaller numbers of contracts, say 1 to 5.
It is known as the "Limit Order Display Rule" or sometimes called the "Show or Fill Rule" (the official name is "Exchange Act Rule 11Ac1-4). It is not a rule that the market makers make very well known for obvious reasons, as we shall soon see. However, knowing this rule can make a big difference in your option profits!
Before we look at the rule, we need to understand some basics to the quoting system used for stocks and options.
Let's say you get a quote on an option as follows:
BID $5 ASK $5-3/4
What exactly does this mean? It means the market makers are "bidding" $5 for the option; this is the price they are willing to pay. They are "asking" $5 3/4; this is the price where they are willing to sell. There is often a lot of confusion to these terms but they are really quite simple if you think of the following analogy. If you sell your house, you are "asking" a certain price, right? If you are buying a house, you put in a "bid" for it. Bid means buy, ask (sometimes called the offer) means sell.
The reason for the confusion is this: Retail investors who buy options are used to paying the "asking" price so they often think the ask price represents the buyers. Similarly, if they sell their option, they are used to receiving the bid price so they think the bid price represents the sellers.
But think about this. If you are buying the option, you need a seller to take the other side of the trade. The reason you can buy the option at the ask price is because the market maker, the person on the other side of the trade, is willing to sell for that price. Now you have a buyer matched with a seller and the trade can be executed. Likewise, if you sell your option, you can be matched with the buyer at the bid.
When you get a quote, the bid price represents the highest bidder and the ask price represents the lowest offer or seller*. This makes sense, as we are not concerned with the person who is willing to sell that same option for some higher amount, say $10, or the one who is willing to buy it for a lower amount such as $1.
Let's go back to the original quote:
BID $5 ASK $5-3/4
Say you wanted to buy the option and did not want to pay $5-3/4 but were willing to pay $5-1/2. You could put in a bid (remember, you are buying the option so you would be a bidder) simply by calling your broker and instructing them to buy at a limit of $5-1/2.
Prior to the "show or fill" rule, the market maker could leave the quote unchanged, letting your high bid of $5-1/2 not be shown as follows:
BID $5 ASK $5-3/4
Say you wanted to buy the under the "show or fill" rule. The market maker must do one of two things: either fill your order or show your order as follows:
BID $5-1/2 ASK $5-3/4
You are now posted as the highest bidder, have narrowed the spread, and have given someone the incentive to sell because of the now higher bid. The markets always benefit from narrow spreads.
Let's say another trader comes along who does not want to sell at the $5-1/2 bid price, but is willing to receive $5-5/8. This trader could put in an order to sell their contracts at a limit of $5-5/8. Assuming the market maker does not fill the trade, the quote now looks like this:
BID $5-1/2 ASK $5-5/8
Again, the spread has been narrowed further and a stronger incentive is now given to the market to buy since the asking price has just been reduced from $5-3/4 to $5-5/8
KEY POINT: It is an exchange policy (at least for the major ones) to have all quotes good for at least 20 contracts.
Here's how you can benefit from this knowledge!
Going back to the original quote:
BID $5 ASK $5-3/4
Say you want to buy a small number of contracts such as 3. Now, if you put in a bid of $5-1/2, the market maker either needs to fill you or show you.
Now, obviously, the market maker does not want to sell you the option at $5-1/2 because he's asking $5- 3/4. But, if he doesn't fill you, he must show your order and change the quote to:
BID $5-1/2 ASK $5-3/4
Here's the benefit! The market maker is thinking: "If I show the order and post the bid at $5-1/2, I may have to buy another 17 contracts since my quotes must be good for at least 20 contracts. I'm really only willing to bid $5, so let me fill this order to get it out of the way!"
How can you profit from this? Think of all the times you bought at the ask price or sold at the bid. Those 1/4 and-1/2 (or much more) point spreads on both sides really start to add up. Placing trades "in between" the bid and ask can make all the difference on your profits, especially for smaller numbers of contracts.
* Technically, the BID and ASK represent the best bid and offer at the margin, the point where price is determined. For example, someone could come in and bid $6 but would be filled at $5- 3/4 because they are outside the margin. The quote would not jump to $6 on the bid even though they are, technically, the highest bidder. It's a technical point, but for our purposes, you can think of the BID as the highest bidder and the ASK as the lowest offer.