The bid/ask spread and how it affects options buyers and sellers

Navigating the Bid-Ask Spread in Options Trading: A Guide for Buyers and Sellers

For options traders who both buy and sell to open positions, understanding the bid-ask spread is crucial for profitable trading. This often-overlooked component of options trading can significantly impact your bottom line, especially when executing multiple trades or working with less liquid options contracts.

What Is the Bid-Ask Spread in Options?

The bid-ask spread in options markets represents the difference between the highest price buyers are willing to pay (the bid) and the lowest price sellers are willing to accept (the ask). For example, if an option contract shows a bid of $1.20 and an ask of $1.35, the spread is $0.15 per share, or $15 per contract (since each standard options contract represents 100 shares).

Unlike stocks, where spreads might be just a penny or two for liquid securities, options spreads tend to be wider and more variable. This difference matters tremendously for traders who actively buy and sell options to open positions.

Why Options Spreads Are Typically Wider Than Stock Spreads

Options spreads are generally wider than stock spreads for several reasons:

- Multiple Strike Prices and Expirations: Each underlying stock might have dozens or hundreds of option contracts with different strikes and expirations, fragmenting liquidity across many instruments.

- Lower Trading Volume: Most individual options contracts trade much less frequently than their underlying stocks.

- Market Maker Risk: Market makers who facilitate options trading take on more complex risks, including volatility exposure and time decay, requiring wider spreads as compensation.

- Implied Volatility Uncertainty: Pricing options involves estimating future volatility, adding another layer of uncertainty that contributes to wider spreads.

The Impact of Spreads When Buying Options to Open

When buying options to open (going long calls or puts), you typically pay the ask price or somewhere between the bid and ask. The wider the spread, the more you're effectively paying above the option's "fair value."

Consider this example for a trader buying calls:

XYZ $50 Call Option (30 days to expiration)

Bid: $1.50

Ask: $1.70

Spread: $0.20 ($20 per contract)

If you buy at the ask price of $1.70, you're essentially starting your trade down $0.20 per share from the midpoint price of $1.60. That means the underlying stock needs to move enough to overcome not just the premium you paid, but also the extra cost from the spread.

Key consideration for option buyers: The spread effectively increases your breakeven price, making it more difficult to profit from the trade.

The Impact of Spreads When Selling Options to Open

When selling options to open (shorting calls or puts), you typically receive the bid price or somewhere between the bid and ask. The spread represents potential value you're giving up compared to the theoretical fair price.

Consider this example for a trader selling puts:

ABC $75 Put Option (45 days to expiration)

Bid: $2.80

Ask: $3.10

Spread: $0.30 ($30 per contract)

If you sell at the bid price of $2.80, you're receiving $0.15 less than the midpoint price of $2.95. This directly reduces your compensation for taking on the obligation represented by the option.

Key consideration for option sellers: The spread effectively reduces the premium you collect, lowering your maximum potential profit and providing less cushion against adverse moves.

How Spreads Differ Across Option Types

The width of bid-ask spreads varies considerably across different types of options:

1. Strike Price Distance from Current Price

At-the-money (ATM) options: Generally have the tightest spreads due to higher trading volume

Far out-of-the-money (OTM) options: Often have wider spreads as a percentage of their value

Deep in-the-money (ITM) options: May have wider absolute spreads due to their higher prices

2. Time to Expiration

Near-term options (expiring within 30 days): Usually have tighter spreads

Longer-dated options (several months out): Typically have wider spreads due to greater uncertainty and lower volume

3. Underlying Stock Characteristics

Options on high-volume, large-cap stocks: Generally have tighter spreads

Options on low-volume, small-cap stocks: Often have much wider spreads

Practical Strategies for Navigating Bid-Ask Spreads

For Option Buyers:

- Use Limit Orders: Never use market orders for options. Instead, place limit orders starting at the midpoint or slightly above the bid.

- Target Liquid Options: Focus on options with high open interest (preferably >1,000 contracts) and daily volume (>100 contracts).

- Consider Spreads in Strategy Selection: When deciding between similar strategies, factor in the cumulative impact of spreads. For example, a single long call might have less spread cost than a multi-leg spread trade.

- Time Your Entries: Spreads are typically widest at market open and close. Consider trading during mid-day when spreads might be tighter.

- Be Patient: Allow time for your limit orders to potentially get filled. The market often moves through various price levels throughout the day.

For Option Sellers:

- Use Limit Orders Above the Bid: Start by placing your sell order above the current bid, perhaps at midpoint or slightly below the ask.

- Sell Premium During Volatility Spikes: When implied volatility increases, option prices and spreads often expand. This can be an opportune time to sell options when bids are higher.

- Focus on Liquid Options: Look for higher open interest and volume to ensure tighter spreads and better fill prices.

- Calculate Return on Capital After Spreads: When evaluating potential trades, factor in realistic fill prices (not midpoint prices) to accurately assess potential returns.

- Consider Rolling Costs: If you might need to roll positions later, factor in the double impact of spreads on both the closing and opening transactions.

Advanced Bid-Ask Spread Tactics

Working with Market Makers

In less liquid options, you're often trading directly with market makers who manage the spread. Understanding their incentives can help:

- Price Improvement Possibilities: Market makers may improve prices if they can hedge their risk efficiently.

- Size Matters: Showing interest in trading multiple contracts might motivate market makers to tighten their quotes.

- Incremental Orders: Breaking a large order into smaller pieces might get you better average fills than attempting to execute all at once.

Spread Cost Calculation for Complex Strategies

For multi-leg strategies, calculate the cumulative impact of spreads across all legs:

Iron Condor Example:

Sell 1 OTM call: $0.10 spread cost

Buy 1 further OTM call: $0.15 spread cost

Sell 1 OTM put: $0.10 spread cost

Buy 1 further OTM put: $0.15 spread cost

Total spread cost: $0.50 per share ($50 per iron condor)

If the theoretical edge on this trade is $0.40 per share, the spread costs would completely eliminate the expected profit.

Real-World Examples of Spread Navigation

Example 1: Buying Calls on a Liquid Stock

AAPL $190 Call (30 days out)

Bid: $5.20, Ask: $5.30, Spread: $0.10

Approach: Place a limit order at $5.25 (midpoint). If not filled within a few minutes, consider moving to $5.30 if you still want the position.

Example 2: Selling Puts on a Medium-Liquidity Stock

XYZ $50 Put (45 days out)

Bid: $1.50, Ask: $1.80, Spread: $0.30

Approach: Place a limit order to sell at $1.60 (slightly above bid). Be patient and allow time for fills. If market conditions change favorably, you might get filled.

Example 3: Complex Spread Trade with Multiple Legs

SPY Iron Condor

Total mid-price for full strategy: $1.00 credit

Combined spreads across all legs: $0.40

Approach: Instead of targeting the midpoint, place your order for $0.80 credit (midpoint minus half the total spread). This gives market makers incentive to take the other side while still giving you a reasonable fill price.

The Psychological Component of Handling Spreads

Many traders struggle with the psychological aspects of navigating spreads:

FOMO vs. Patience: The fear of missing out drives impatient trades at poor prices. Developing discipline to walk away from unfavorable spread situations is crucial.

The Sunk Cost Fallacy: After researching a trade idea, traders often feel compelled to execute even when spreads are unfavorable. Be willing to abandon ideas when execution costs are too high.

Understanding True Costs: Many traders focus on commission costs while ignoring much larger spread costs. Train yourself to calculate and consider both.

Conclusion: Incorporating Spread Management into Your Trading Plan

For traders who both buy and sell options to open positions, mastering the bid-ask spread is essential for long-term profitability. Here's a summary of key practices:

Incorporate spread costs into all trade planning: Calculate break-even points and profit targets using realistic fill prices, not theoretical mid-prices.

Be selective about which options you trade: Focus on contracts with appropriate liquidity for your position size.

Use limit orders exclusively: Start at advantageous prices and work toward the market if necessary.

Develop mechanical rules for spread negotiation: Create personal guidelines for how long to wait for fills and when to adjust orders.

Track your execution quality: Review your fills against the prevailing bid-ask spread to identify patterns and areas for improvement.

Remember that even small improvements in execution across many trades can significantly impact your overall trading performance. The trader who consistently gets better fills on options trades possesses a meaningful edge in the market that compounds over time.

By focusing on managing spreads effectively when both buying and selling options to open positions, you'll maximize the theoretical edge of your strategies and keep more of your potential profits.