How bid-ask spread works

The bid-ask spread is the difference between the highest price a buyer is willing to pay (the bid) and the lowest price a seller is willing to accept (the ask) for an options contr

The bid-ask spread is a fundamental concept in financial markets, representing the cost of executing a trade. When you want to buy an options contract, you pay the ask price, and when you want to sell, you receive the bid price. The difference between these two prices is essentially the profit margin for the market makers facilitating these transactions. A wider spread indicates less liquidity or higher risk for the market maker, leading to higher transaction costs for traders. Conversely, a narrower spread suggests high liquidity and lower transaction costs.

For options, the bid-ask spread can be particularly impactful due to their often complex pricing and varying levels of liquidity compared to underlying stocks. Options on highly liquid stocks with large trading volumes typically have tighter spreads. However, options that are far out-of-the-money, have very short or very long expirations, or are on less popular underlying assets tend to have wider spreads. This wider spread means a larger immediate loss from entering a position, as the price you pay to buy is significantly higher than the price you would receive if you immediately tried to sell. Therefore, options traders must factor the spread into their profit calculations, as it directly reduces potential gains and amplifies potential losses. Understanding the bid-ask spread helps traders identify the real cost of their trades and evaluate the fairness of the market price they are getting.

Why it matters

- The bid-ask spread is a direct transaction cost for options traders. Every time you buy at the ask and sell at the bid, you incur this cost, which can significantly impact your overall profitability, especially for frequent traders or when dealing with thinly traded options.
It serves as an indicator of an option's liquidity. A narrow spread suggests a highly liquid option with many buyers and sellers, making it easier to enter and exit positions quickly at competitive prices, whereas a wide spread indicates lower liquidity and potentially greater difficulty in executing large orders.
The spread influences the perceived value of an option contract. When the spread is wide, the mid-point (the average of the bid and ask) might be used as a theoretical fair value, but the actual entry and exit prices will always be at the extremes, requiring the option price to move more significantly in your favor to become profitable.
Understanding the bid-ask spread aids in order placement strategies. Traders might choose to place limit orders between the bid and ask to potentially obtain a better price, although this carries the risk of the order not being filled if the market moves away.

Common mistakes

- Ignoring the bid-ask spread when calculating potential profits or losses. Traders often look only at the midpoint price for analysis, but the actual transaction occurs at the bid (when selling) or ask (when buying), meaning the immediate 'cost' of opening a position is the spread itself, not just commission.
Trading options with very wide bid-ask spreads without considering the impact on execution. Entering and exiting positions with wide spreads means a larger loss from the outset, requiring a greater price movement in your favor just to break even, making it harder to profit.
Always using market orders, especially for options with wide spreads. Market orders guarantee execution but at the worst available price (the ask for buying, the bid for selling), thereby giving up the entire spread to the market maker. Using limit orders can help to negotiate a better price within the spread.
Failing to understand that option chains, particularly for far out-of-the-money or long-dated options, naturally have wider spreads due to lower trading volume and higher perceived risk by market makers. Expecting tight spreads across all options can lead to disappointment and expensive trades.

FAQs

What causes the bid-ask spread to be wide or narrow?

The width of the bid-ask spread is influenced by several factors, including the liquidity of the underlying asset, the trading volume of the option itself, volatility, time to expiration, and the perceived risk by market makers. Options with high trading volume and strong liquidity tend to have narrower spreads.

How does the bid-ask spread affect the profitability of an options trade?

The bid-ask spread is a direct cost embedded in every options trade. When you buy an option, you pay the ask price, and when you sell, you receive the bid price. This difference means you start with a built-in loss equal to the spread, requiring the option's value to move by at least that amount in your favor before you can achieve a profit.

Can I avoid paying the full bid-ask spread?

You can attempt to mitigate the impact of the bid-ask spread by using limit orders instead of market orders. By placing a limit order between the current bid and ask prices, you might be able to get a better execution price, although there's no guarantee your order will be filled.