by Russ Allen, Online Trading Academy Instructor
Online Trading Academy Article of the Week
Put and call options provide several ways to hedge, speculate or generate passive income. We have written about many of those in the past.
No matter what options strategy you use though, there is one factor that must always be taken into consideration. That is the bid-ask spread on the option prices.
Explanation of a Bid-Ask Spread
Think of a used-car lot. The car dealer “makes a market” in used cars. He stands willing to buy a car from anyone who wishes to sell or trade one in. For any particular car that is offered to him, he decides what he is willing to pay. Let’s call it $7,000. That is his bid. If you want to sell the car to him for that price, you can turn over the keys and collect your check.
If you do sell the car to the dealer, he will then offer that car for sale to customers. He will ask a higher price. Let’s call it $10,000. If the car is advertised for that Ask price, then the first buyer to turn up with buying power (cash or credit) of $10,000 can own the car.
The $3,000 difference between the “Bid” price and the “Asking” price would be a typical dealer markup for a used car, the Bid-Ask Spread. It represents a markup of $3,000 on $7,000, or 42% of the bid price. Or you could say that the $7,000 bid is a 30% discount from the asking price ($3,000 of $10,000). Both statements are true.
The dealer’s markup is no secret. He provides services to both buyer and seller, and the markup is his compensation for doing so. He makes it convenient and fast for both buyers and sellers to do what they need to. Their alternative would be to attempt on their own to find a party to deal with at the exact time that they need to make it happen. This is a time-consuming and uncertain process.
So, although some dealer markup is inevitable as the cost of convenience, that doesn’t mean that we are forced to accept any bid or asking price the dealer may proffer. If we are the seller and we know that a fair retail price for our car would be $10,000, then we will try to get the dealer to pay us a price that is as close to that as possible. If we can get him to come up to $8,000 or $9,000 then we are that much better off. The same is true if we are the used car buyer. We see the $10,000 price on the window but we know that the dealer paid less. The lower a sale price we can negotiate, the better off we are.
We don’t know to what degree the car dealer is willing to negotiate until we try; but he should have a minimum Bid-Ask Spread he is willing to accept. If we are selling, when the dealer bids $7,000 we could counter with an asking price of $9500. It may be accepted, or not. If not, we could counter with an offer of $8,000. And so on until we settle on a price that both parties are willing to agree to. What the dealer will agree to depends on how badly he needs to do that particular deal today, and on how much competition he has. He’ll hold out for better margins if he is the only dealer in town. If he has competitors next door on either side, he’ll be more willing to reduce his Bid-Ask spread to make the deal.
What applies to used-car prices also applies to option prices. We don’t have to do business at the dealers’ prices. We can negotiate. In the case of buying or selling options, “negotiating” is as simple as using a Limit type order and specifying the price at which we are willing to make the trade. Our order will go through if the option dealer (market maker) is hungry enough. If not, it will remain unfilled. We are then free to cancel that order and try again at a slightly different price.
Below is a partial option chain for the exchange-traded fund called SPY.
Note above that the latest price for SPY was $218.26. The closest option strike price to that was $218. For the Call options at the $218 strike, the Bid was $.82 and the Ask was $.85. That was a dealer markup, or bid-ask spread of $.03. This is pretty modest. Even if we had to pay it all (by buying at the ask and then selling at the bid), that was not a huge difference. This is because many traders of all types buy and sell options on SPY.
In contrast, look at the options below for a slightly different exchange-traded fund. Its symbol is IVV and it covers “core” stocks within the S&P 500. It was at a very similar per-share price, at $219.50.
See above that at the closest strike price to the stock price, $220, the Bid was $.35 and the Ask was $.65. That’s a huge bid-ask spread.
This comparison is shown to make two points:
We do not have to accept the dealer’s stated prices with either asset. We can use limit orders to name our own price. Those orders may or may not be filled. If not we can try again, or walk away.
Some assets have bigger bid-ask spreads on their options than others. The SPY options had a spread of $.03 on an $.82 base – less than 4%. The IVV options had a spread of $.30 on a $.35 base – a spread of over 85%. That is pretty rich – we might want to just look elsewhere. A markup of less than about 10% is acceptable. This big of a bid-ask spread makes it very costly to trade these options. Clearly, if we did decide to trade the IVV options for some reason, it would be imperative to use limit orders and try to get the best price we possibly could.
That’s all for today. Remember, in your option trades – watch the bid-ask spread!
