ES Friday 9-22-17 : Hot Topic

The Bid/Ask Disadvantage

A worked example

I've been doing some thinking since I wrote this article and thought that I would put in a theoretical worked example to explain (from another angle) the effect of the bid/ask on executing a strategy.

Here are a before and after DOM (Depth Of Market) screen laid out as a table:

BEFORE AFTER
BID ASK BID ASK
1320.00 400 1320.00 400
1319.75 400 1319.75 401
1319.50 400 1319.50 400
1319.25 400 1319.25 400
1319.00 400 1319.00 400
1318.75 400 1318.75 399
400 1318.50 400 1318.50
400 1318.25 400 1318.25
400 1318.00 400 1318.00
400 1317.75 400 1317.75
400 1317.50 400 1317.50
400 1317.25 400 1317.25

Image that this is the scenario with the number of contracts bid/asked at each level being 400. You buy 1 contract at market (i.e. price of 1318.75) and aim to make 1 point with a 1 point stop.

The number of contracts asked at 1318.75 drops by 1 (because you bought 1) and the number of contracts asked at 1319.75 increases by 1 (because that's your target that you've just entered a bid at).

Now look at the number of contracts that have to be bought in order for you to achieve your target. Somebody has to buy all the asked prices up to your target and clear out the 400 contracts ahead of you in the queue. That's 2000 contracts.

Now look at your stop. As soon as 1 contract trades at your stop then your stop is triggered (of course you can override this and let more trade there before you trigger it). You only need 1,201 contracts to be sold in order for your stop to be triggered.

So when you execute this strategy, you are doing so with an edge which says that the market is more likely to cruise through 2000 contracts on the buy side than it is to eliminate 1,201 contracts on the sell side. Is your edge really that good?

Now consider executing a long trade when the sum of all the visible asks are more than the sum of the visible bids. You are at an even worse disadvantage than the simple even distribution of bids and asks that I have shown here.

What if the ES traded in tick sizes of 0.1 points per tick?

Here are the same tables as above:

BEFORE AFTER
BID ASK BID ASK
1319.8 160 1319.8 161
1319.7 160 1319.7 160
1319.6 160 1319.6 160
1319.5 160 1319.5 160
1319.4 160 1319.4 160
1319.3 160 1319.3 160
1319.2 160 1319.2 160
1319.1 160 1319.1 160
1319.0 160 1319.0 160
1318.9 160 1318.9 160
1318.8 160 1318.8 159
160 1318.7 160 1318.7
160 1318.6 160 1318.6
160 1318.5 160 1318.5
160 1318.4 160 1318.4
160 1318.3 160 1318.3
160 1318.2 160 1318.2
160 1318.1 160 1318.1
160 1318.0 160 1318.0
160 1317.9 160 1317.9
160 1317.8 160 1317.8
160 1317.7 160 1317.7

I've reduced the number of contracts at each level to 160 (400 / 2.5) because we've decreased the tick size from 0.25 points to 0.1 points per tick.

What you see in these two tables is essentially how the pit traded S&P 500 future trades. Because it's not electronic (during RTH) you can't see an accurate DOM as you can with the ES.

With our same strategy of buying at the market and aiming for 1 point profit with a 1 point stop we now have a situation where somebody needs to buy 1,760 for our target to be filled or sell 1,441 contracts for our stop to be hit.

It should be clear from this, that it is more advantageous to trade this particular strategy (ceteris paribus) using ES tick sizes of 0.1 instead of 0.25. This I believe applies to most trading strategies of this nature.

The person who benefits from the wide spread is the market maker who is sitting on either of the spread.