Options Trading

Going to the Market

Definition

The bid/ask spread is the difference in price between the price a buyer is willing to pay (the bid), and the price a seller is welling to sell (the ask).

The most basic example is a market, or garage sale. You find an item you would like to buy and ask the seller how much they would sell it for. They tell you $10. You may be willing to pay more, but you aren't going to say that right away, so you tell them you will pay $5. The bid/ask spread is $5 Bid, $10 Ask, a $5 difference. Of course, both of you are probably willing to budge a little, so you might haggle over the price. The seller says they could let it go for $8, and you counter by saying you'll pay $7. The bid/ask spread has just narrowed to $1. At this point, one of you may cave in. The seller might "hit the bid" and sell it to you for $7, or you may have to haggle a bit more. Maybe you settle on what's known as the mid-price, $7.50, and a trade is made.

The same dynamics are at play in the stock market.

Stock Bid/Ask Spread

ADBEstock

When you buy or sell a stock there is always a bid/ask spread to contend with. In the screenshot above you can see the spread for ADBE stock. Here you can see the spread is $616.66 Bid / $617.04 Ask for a spread of .38 cents, which when you are buying a stock worth over $600, doesn't amount to much as a percentage. Just a tiny fraction of 1%.

You could choose to use a limit price order to try and haggle your way to a mid-price in between the two, say at the mid-price of $616.85, or you could simply hit the market order button. When you do that your buy order will automatically buy the stock at the ask price, $617.04, or sell the stock at the bid price, $616.66.

Most stocks will have a tight enough bid/ask spread that you won't need to worry about it. However, there are some very thinly traded stocks out there that do have sizeable spreads, in which case it would be worth considering if it is really worth it. Stocks like these are pretty rare, and unless you are searching out some really obscure companies, it's not an issue you will probably run into.

Options Bid/Ask Spread

With options trading the bid/ask spread takes on more importance than it generally does with stocks. There are a couple of reasons for this, but first let's consider how an option trade is made.

When you decide you want to buy ADBE $620 call options expiring a month from now, you have to realize that that's sort of an obscure idea. More than likely there isn't another retail trader like you sitting at home thinking to himself, "What I'd really like to be doing right this very minute, with all of the thousands of stocks available to me, is to be selling an ADBE $620 call expiring next month."

No, the odds of that happening are extremely slim. If the stock market relied on that chance encounter happening, no trades would ever get done. So options have what are called market makers, and as their name implies, their duty is to ensure a fair and orderly market by providing liquidity to the assets that they are in charge of.

So, in our example, there is a market maker for ADBE options that is sitting at a screen and constantly updating the option chain with both bids and asks on all the different strike prices and expiration dates. Remember, importantly, that his/her job is not to give you a great deal, it's simply to offer you a price that you can buy, or a price that you can sell at. They provided you a market to shop at or sell your goods. In stocks without much interest the bid/ask spreads will be quite wide, while stocks with more interest will have tighter spreads.

I was an options trader in Chicago. My job as an independent trader was to provide liquidity to the options market on the floor of the Chicago Board of Trade. When a farmer in Iowa called his broker in Chicago and asked what price he could trade the Soybean November $450 calls at, his broker would yell out into a sea of traders, "Nov $450 calls!" and we would immediately reply by yelling out two prices, a bid and an ask, "$2.20, 2.40!" He would relay that to the farmer who might then tell him to sell 100 contracts at $2.30. Remember, we didn't know beforehand if we would be buying or selling, we just made a market for the option. Now, when the broker yells to us that he'll sell 100 at $2.30, we'd have a tighter market. There would be our bid at $2.20 and the farmer's ask at $2.30. At this point, we could either choose to buy those at $2.30, to raise our bid, or to do nothing. In the meantime, a third party could enter the fray, say a farmer in Brazil who saw the $2.30 ask pop up on the quote board. He calls his broker and tells him to buy at $2.30. And with that, a trade is made.

Today, this is all done on the computer in fractions of a second. But there still has to be at least one person, the market maker, who is willing to take either side of a trade for a certain price. Without that market maker, most stock's options chains would remain empty all day long.

One last point to keep in mind is that the market maker doesn't have a preference for whether the stock goes up or down. He will take either side of the trade. In order to do this he hedges his trades. If he sells you calls, he turns around and buys an amount of stock that will offset the risk of those calls. That is called hedging. But if all he is doing is hedging his risk so that there is virtually no risk, how does he make money? Well, it all comes back to that bid/ask spread. If the mid-price is the actual fair value price (it isn't necessarily, but for our purposes we'll assume it is), then any price he pays below that value, or sells above that value, will essentially be his profit.

Okay, now that we've established that options trading requires a market maker in order for you to show up out of the blue and buy some obscure option, and we understand that this person's job is not purely altruistic, let's figure out why this is important.

ADBE option chain

In the above ADBE option chain you can see that the $620 call market is $35.80 Bid / $36.40 Ask. This is very good. We aim for a spread of 5% or less in our option's trading. We calculate that like this:

(Ask - Bid) / Mid-Price
.60 / 36.10 = 1.7%

This tight spread guarantees that you can get both in, and out of the trade without paying a huge premium to do so. Getting into a trade isn't usually the problem. You can take your time, work the mid-price, and hopefully get filled there. If not, you can just pass on the trade. Getting out is where the bigger problem presents itself, especially if the market is moving fast and you need to cut your loss off quickly. In that situation with the ADBE spread this close you could simply sell at the bid price ($35.80 instead of the mid-price $36.10) to guarantee you get filled and get out of the trade. This wouldn't get you a great deal, but at least it would cut your trade off for just .8% below the mid-price. Less than 1% on a trade that is probably only 3% of your portfolio to begin with, means just a couple hundredths of a percent to your portfolio. Certainly a small enough amount not to worry about.

But what if the spread were wider? Say it was $34.00 Bid / $38.00 Ask.

(Ask - Bid) / Mid-Price
4.00 / 36.00 = 11.1%

Now instead of a 1.7% spread, we have an 11.1% spread. Okay, when you are entering the trade, you could still try and get the mid-price (assuming that's the fair value), and maybe you would. So on the entry we'd say the wide spread didn't really cost you much. But the exit is where things can get expensive. Again, let's say the market is moving quickly and you need out of the trade. Now when you go to sell at the bid price you are paying a much higher percentage. In the example above you would now be selling at $34.00 instead of the mid-price $36.00. That's a 5.5% difference, which is a .17% extra hit to your portfolio if the trade size was 3% of your portfolio.

Obviously each person's trade size and risk is different. You may decide that .17% is still "close enough" for you. At Wanderer we've determined that a good rule of thumb is 5%. There are so many trades available to us on any given day, so many options that have tighter spreads, that it just seems pointless to actively trade stocks whose options market isn't actively traded with a good bid/ask spread. Starting in the hole like that is like giving a huge tip to the market maker just for allowing you to sit down at the table.

And that wraps up the bid/ask spread. Now you understand where it comes from, why it's important, and how to calculate it. Hopefully that will help you to narrow down the best stocks and options to screen for your own trading.

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