Option Bid-Ask Spreads Can Hurt You

I have always wondered why there has to be a spread between what you can buy an option for and what you can sell it for. The simple answer is someone needs to make money and that someone is usually the market maker. All kidding aside, many option traders do not even think about the bid-ask spread. As a young retail option trader, I was cognizant of the spread. I did not want to be down more than I needed to be entering a trade because of a ridiculous spread between what I can buy and then sell the option for. To my surprise, many option traders do not even think about that. Let’s take a look below.

Middling the market means you try to get close to the middle of the bid price and ask price. This is done whether buying or selling. If buying, the order should be filled at the ask price, but option traders try to buy closer to the mid-price. For selling, the bid price should be filled, but option traders will move close to the mid-price to bring in a bigger premium.

Take a look at the above example. The 115 calls have a bid of 3.85 and an ask of 3.90. The spread between the two is 0.05 (or $5 in real terms. The call can be bought for 3.90 ($390) or sold for 3.85 ($385). There is not much room to “middle,” but the option trader is not losing much money ($5) whether the option was bought or sold.

When the spreads are bigger, yes, you can middle the market to some degree at times, but it is debatable whether you could do the same when exiting the position. Most likely it cannot be done, so an option trader needs to make up the difference just to have the position trade at breakeven.

In the example above, the bid is 4.20 and the ask is 5.00. If the option trader wanted to buy the 160 call, the ask is 5.00 but an option trader might try to “middle” the market and offer 4.60 (or the middle between the bid and ask). If that is not filled, he or she may work their way up closer to the ask until filled. The problem becomes that many times an option trader cannot do the same or near as much middling when trying to sell the option based on the bid. I had one student call it the “roach hotel.” They will let you in but not out!

The bottom line is to be careful of wide bid-ask spreads. What are wide bid-ask spreads? Consider the 10% rule. The spread between the bid and ask cannot be more than 10% of the bid. For example, if the bid is 2.50, the ask should not be more than 2.75 (10% of 2.50 is 0.25). I like to tell my students that they will know from experience what they are willing to accept and not accept as option traders. Like a lot of things when it comes to option trading, experience cannot be taught right away.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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