In case you haven't noticed, Dr. James Schultz (aka "Doc" Schultz) has been absolutely crushing it on his show "From Theory to Practice."
On an episode titled "Inside Fills," Doc Schultz zeroes in on a topic that builds on a recent blog post covering portfolio management. Dr. Schultz drills down into the execution side of portfolio management. And while the primary focus is guidance on how to work the inside of the bid-ask price spread, the good doctor also passes on some other valuable nuggets of wisdom.
Taking a broader perspective for a moment, imagine a car dealership and its basic business model. Essentially, the dealer buys cars (units) from the factory for one price, and then sells the cars (units) for a higher price. The difference between these prices is the "spread" that the dealership collects which contributes to profit (less overhead).
For example, a dealer buying cars for $15,000/unit from the factory, and then selling them for $20,000/unit to a customer, is making $5,000 per trade.
Market makers may be thought of as dealers of securities operating under a very similar regime. They are buying at one price, and selling at a higher price - the only difference being that in this case the units are financial securities rather than a high-sticker consumer good.
For example, if a call option in XYZ has a bid price of $1.00 and an ask price of $1.20, the market maker can collect a profit spread of $0.20 by purchasing on the bid and selling on the ask.
What Dr. Jim recommends on his show is using this understanding of the market to work the middle of the bid-ask spread to optimize your execution. Let's say you had previously sold the option discussed above for $2.00 and you are now seeking to close the position.
Rather than simply paying the offer of $1.20, Doc Schultz is suggesting that you first try to get filled "inside" the market, by bidding $1.10 or $1.15.
While these are only nickels and dimes on a per trade basis, the total savings could be exponentially higher when applied to hundreds or thousands of trades.
We hope you'll take the time to watch Dr. Schultz's full rundown on this topic when your schedule allows.
If you have any questions about "inside fills," we hope you'll follow up with Dr. Schultz directly by reaching out at firstname.lastname@example.org, or using the comment section below.
Thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.