The Bid-Ask Spread

Good Trades at Fair Prices

Buy and Sell
Bid and Ask. Google Images

Your your first trade can be a frightening experience, regardless of what you are trading. Until that first trade is behind you, the education process has been theoretical -- with nothing at risk. Pulling the trigger on that first order changes the game. There are two new things in your life: the possibility of earning a profit and the possibility of incurring a loss.

The information in this article is designed to help you avoid getting ripped off.

 

Fundamental truth: The transaction price is very important to your long-term success. The one exception is for the long-term trader who tends to hold positions for years, if not decades. As an option trader, your holding period tends to be short (few days to a few months, and each transaction represents an opportunity to lose money (i.e., by paying too much).

What a Trader Sees

When ready to place an order, you see "the market" for the options That market consists of a bid price and an ask price. If you enter a "market order", then -- in theory:

  • When you are a buyer, you pay the lowest price that anyone is willing to collect when selling the option.
     
  • When you are a seller, you collect the highest price that anyone is willing to pay when buying the option.

However, it does not work that way in today's computerized marketplace. The broker's software is designed to find the lowest or highest "published price" for the option.

Translation: The program is not designed to negotiate prices. It merely finds the best available price and executes your order. If someone is willing to sell at a lower price -- but does not advertise (i.e., publish) that price, then your market order cannot find that lower price and you will pay the lowest published ask.

For example, one market maker may publish a bid price of $1.20 and an ask price of $1.40. For this discussion, let's assume that this market maker represents both the highest current bid and the lowest current offer at the time your market order reaches the floor of the exchange. When that happens you will pay $1.40 when buying and collect $1.20 when selling. Notice that it does not pay for this market maker to bid any higher (nor offer to sell at any lower price) because the computerized program is designed to pay his/her prices (unless another trader publishes (i.e., displays) a better price.

Now look what happens when you enter a . If you bid $1.35, there is a possibility that the market maker (or a different market maker) will be willing to accept your bid. If that trader wants to sell the option, your $1.35 bid is higher than anyone else's bid (currently $1.20) and it may be very tempting to sell the option to you. After all, this trader does not know whether you will raise your bid price to $1.40, you will stay firm with the $1.35 bid, or cancel the order. In other words, there is some incentive to sell the option to you at a price that is almost as high as the asking price. 

The same situation obtains if you are a seller.

The market maker may be very willing to pay $1.25 to own this option. There is no need for him/her to advertise that higher bid because (in this example) there is no one else bidding the higher price and he/she would only be competing with him/herself. But if your limit price is $1.25 (i.e., you will accept a minimum of $1.25 when selling the option), there is a reasonable chance the market maker will step up and take your offer. 

Bottom Line: Do not enter market orders when trading options. Your broker may encourage the use of market orders, but keep in mind that the broker does not get paid (collect a commission) until your order is filled.

 Unless there is some dire emergency during which you MUST buy/sell this option right now -- or something bad will happen -- there is no urgency. Enter a limit order and, if the order is not executed in a timely manner (i.e., perhaps 30 seconds), you can raise the bid (or lower the offer) and buy the option at the published price. It almost never hurts to seek a because execution because these nickels and dimes add up over the years.