Two Tricks to Find Fair Value on Illiquid Options. Jim Schultz Shows Both

Key Concepts

• Bid-Ask Spread: The difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask).
• Mid-Price: The average between the bid and ask prices, often used as a starting point for order execution.
• Illiquid Stocks: Assets with lower trading volume, resulting in wider bid-ask spreads and increased difficulty in determining "fair value."
• Extrinsic Value: The portion of an option's premium that is not intrinsic value; it represents the time value and volatility component.
• Put-Call Parity (Spread Context): The principle that the sum of prices for equivalent vertical spreads on both the put and call sides must equal the width of the strikes.

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1. Understanding Bid-Ask Dynamics

In any market, the bid price is what you receive when selling, and the ask price is what you pay when buying. In functioning markets, the ask is always higher than the bid to compensate the market maker (the counterparty).

• Execution Strategy: Traders should avoid buying at the ask or selling at the bid. Instead, the recommended methodology is to "anchor" orders at the mid-price.
• Liquidity Impact: In highly liquid stocks (e.g., SPY, Amazon), spreads are tight (pennies wide), making the risk of a poor fill minimal. In illiquid stocks (e.g., Micron), spreads can be several dollars wide, necessitating more precise tools to identify fair value.

2. Methodology for Determining Fair Value

When dealing with wider spreads, the speaker suggests two primary analytical tools to "dial in" the fair value:

A. The Vertical Spread Summation Trick

This method uses the relationship between put and call spreads to verify pricing:

1. Process: Identify a vertical spread on the put side and its equivalent on the call side (using the same strikes).
2. Calculation: The sum of the prices of the put spread and the call spread must equal the total width of the strikes.
3. Application: Start by analyzing the out-of-the-money (OTM) side of the chain, as these markets are typically tighter and provide a more accurate reflection of fair value. Once the OTM value is established, you can "back into" the fair value of the opposing side.

B. The Extrinsic Value Tool

For standalone options in illiquid markets, the extrinsic value column is a critical indicator:

1. Concept: Since OTM options have zero intrinsic value, their entire premium is extrinsic.
2. Application: By looking at the extrinsic value column in a trading platform (like tastytrade), a trader can ignore the noisy bid-ask spread and see the "true" value of the option.
3. Execution: Use the extrinsic value as the starting point for your limit order, then adjust (penny up or down) to find a fill.

3. Key Arguments and Perspectives

• Market Competition: The speaker argues that due to high competition among market makers, the risk of receiving a "terrible fill" is very low. Traders should not fear the wide spread but rather use it as a starting point for price discovery.
• Strategic Focus: While it is tempting to trade illiquid names, the "bread and butter" of a successful trading strategy should remain in highly liquid markets where spreads are naturally tight.
• Risk Management: Even when trading illiquid names, traders must be aware of the capital requirements. For example, buying an option with $130 of extrinsic value represents a $13,000 exposure, which requires a sufficiently sized account.

4. Notable Quotes

• "We want to be playing in the same sandbox that everybody else is playing in."
• "The tighter the market, the truer the midpoint is going to be as a representation of the fair value."
• "Forget about the bid, forget about the ask right now. Just look at the extrinsic value and that can really clue you in."

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Synthesis and Conclusion

When trading illiquid stocks, the bid-ask spread can be misleading. To navigate this, traders should move away from simply looking at the bid and ask and instead utilize structural market relationships. By using the Vertical Spread Summation (ensuring put/call spreads equal the strike width) and the Extrinsic Value (isolating the time value of OTM options), traders can effectively estimate fair value. While these tools assist in trading illiquid names, the primary focus should remain on liquid markets to ensure the most efficient execution.