Virtual Options Trading
Virtual Trading (VT) is a general term referring to hypothetical trades made by a trader for either practicing or for evaluation of his/her methodology. You may have also heard the term “Paper Trading” which is usually used interchangeably with VT. In fact, the days prior the rush of personal computers in all aspects of life (trading included) virtual trades were done on paper instead of being done in a real account hence the term ‘paper trading’. Nowadays the astounding massive use of personal computers and the extensive use of internet have made virtual trading possible in an amazingly convenient way. The virtual trader does not have to adjust his notes for corporate actions, dividends and other labor intensive stuff. All these can be done in a simulated computer environment and plenty of information including price quotes is readily available from the internet. There are many sites who offer free virtual trading either for either educational or promotional purposes and this is an excellent chance for all types of traders to grasp this pennyworth opportunity for practicing their skills in a risk free environment. VT via a simulator in simple tradables such as stocks is done decently in most available simulators today especially for long term or position traders. However, VT on complex tradables such as options is a more complicated matter. In the present article I will try to describe in detail a few concepts (usually half-mentioned by other articles in the same subject) you must take into account when trading option strategies in a simulated environment.
1st Concept: Equity-Settled Options
Generally, options are either physical-settled or cash-settled. Physical-settled means that in the case of option exercise the writer of the option must sell the underlying entity (shares, bonds etc) to the option buyer. In effect, the exercise of a naked option renders the buyer and writer having long and short positions respectively in the underlying. Cash-settled means that if the option is in the money the writer simply pays (and the buyer receives) the difference between the settlement price of the underlying and the strike price of the option. The latter method is usually performed in the case of index options where it is practically impossible for the option writer to deliver a precisely weighted portfolio of 100 or more stocks to the buyer. A virtue of cash-settled options is that you don't end up with any positions that would generate margin calls. Therefore, what you must demand from your trading simulator provider is that in the case of exercise or assignment of physical-settled options you must end up with a long or short position in the underlying. This is absolutely critical for a decent simulation of options trading.
2nd Concept: Corporate Actions
You trading simulator must call all possible corporate actions and modify your account accordingly. Stock options must be modified when mergers or acquisitions take place and a modification is due in reality. Also, when you have stocks in your virtual account that pay dividend you must collect that dividend and when you are short these stocks you must pay the dividend.
3rd Concept: NBBO and Complex Options Trades
The National Best Bid and Offer (abbreviated: “NBBO”) is a term applying to the SEC requirement that brokers must guarantee customers the best available ask price when they buy securities and the best available bid price when they sell securities (www.investopedia.com). Simply put, the NBBO is the highest bid and lowest offer for a security in all exchanges and market makers. Since there are NBBOs for simple option positions (long call, short call, long put and short put) there are also ‘implied’ NBBOs for more complex option positions such as spreads, butterflies, condors etc and here is where things get more complicated (note the word ‘implied’ above). Consider for example the following hypothetical case: The NBBO for the 80 put is 1.2/1.4 (1.2 bid and 1.4 offer) and the NBBO for the 90 put is 1.5/1.6 (1.5 bid and 1.6 offer). The implied NBBO for the spread is therefore 0.1/0.4. This is because if you want to buy the spread you must buy the 90 put and sell the 80 put thus paying $0.4 ($1.6-$1.2) and if you want to sell the spread you must sell the 90 put and buy the 80 put thus getting $0.1 ($1.5-$1.4). Now, many brokerages allow you to put a vertical put spread as one order with two legs (a long leg and a short leg). You are charged commissions as if the spread legs are done separately but your order is transmitted as one order. This is a great advantage from a risk management point of view because you save time and you may define exactly the debit/credit you want for the spread. The one leg is executed only when the other leg can also be executed. There is a significant drawback however: In real trading both legs of the spread must be executed on the same exchange and by the same market maker. In other words, spreads (being not standardized contracts such as puts and calls) are executed at the discretion (and by the manual action) of a market maker. Since the NBBO you get for the spread can be constructed by bid/asks from different exchanges and different market makers your order to buy or sell the spread in its NBBO may not be executed. Caution!. This is not taken into account by virtual trading simulators and you may get unrealistic fills using spread NBBOs. When you want to virtual trade complex option positions always leg in the position (that is, trade each leg separately).
4th Concept: "Shaving" the Bid/Ask Price
Normally, when you see for example a Bid/Ask of 1.6/1.8 for an option this means that the theoretical fair value for the option is somewhere in the middle (that is, approximately 1.7). Market makers buy below the fair value (at 1.6) and sell above the fair value (1.8) thus making a risk free income. This does not mean that a market maker is absolutely not willing to sell you the option for say 1.75 but he/she has no benefit of posting the 1.75 ask price since he/she may find a buyer for the contract at 1.8. An important thing to bear in mind is that the in-between orders are processed individually by market makers and this cannot be incorporated in a trading simulator. In effect you have to buy on the ask price and sell on the bid price when trading virtually and you are not let getting filled in between the bid and ask (aka “shaving” the spread). This is not so important factor when you simulate few trades in tight bid/ask spreads but it seriously skews the simulation results when dealing with many trades.
5th Concept: American-Style Options and the 'Threat' of Early Assignment
The buyer of an American-style option has the right to exercise the option any time until the option expires. When the buyer exercises such an option, the other parity (the writer of the option) is said to be “assigned”. Option writers are usually afraid of assignments for equity-settled options even though theoretically it is to their merit. When an option is exercised, the buyer purchases the tradable at the strike price thus getting only the intrinsic value of the option. The extrinsic value (aka time value) of the option is left to the writer of the option. Why do the writers then afraid of assignments?. The answer is simple: an early assignment will leave them with a long or short position in the underlying which may distort their risk profile and money management rules. This is even more present when one leg of a multi-leg option position is assigned. Consider the case of a trader who has sold a 80/90 vertical credit bear call spread (short the 80-call and long the 90-call) in SPY (S&P Dep Receipts) and he is assigned in the 80-call. He looses his 80-call and gets a short position in the SPY. The short position in SPY combined with the long 90-call equals a synthetic long put which is something different than the credit bear call spread he started initially.