Option Investor
Educational Article

Working The Spread

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Stock traders may not care about the bid/ask spread, especially now that they are so tight with most equities with the advent of decimalization. But for option traders, dealing with the spread between the bid and ask can often make the difference between a winning or losing trade.

For many seasoned options traders this will be old hat, but judging by some of the emails I have recently received, there are some newbies that could benefit from a basic discussion of how to work with the spread to reduce risk and hopefully increase reward.

First off some simple definitions. The Bid is the price that another trader (or market maker) is willing to pay for the specified option. The Ask is the price at which another trader (or market maker) is willing sell. If you have access to real-time quotes, the Bid represents the best or highest Bid, while the Ask represents the best or lowest Ask.

The difference between the Bid and the Ask is commonly referred to as the Bid/Ask spread and for the remainder of this discussion, I will simply refer to it as the Spread. The reason the spread is so important to us as option traders is that when we buy an option, we typically buy at the Ask and when we sell, we do so at the Bid. So when we buy an option, we are immediately in a loss position, as the option can't be sold for what we paid for it until the underlying stock moves sufficiently for the Bid price to reach the level of the Ask when we entered the trade. I know that sentence is a mouthful, so let's look at a couple of examples to demonstrate the concept.

IBM is currently trading near $85 ahead of their analyst meeting tonight. Let's assume for the sake of argument that we wanted to take a speculative trade that the market won't like what they have to say and want to buy some June puts ahead of the meeting to profit from the resulting drop. My broker window tells me that the JUN-80 Put is Bid at $1.45 and the Ask is $1.60. So the spread is $0.15. So if we placed a Market Buy order for that option, it would cost us $1.60. However, if we turned right around and decided to sell that option, we would only receive $1.45 for it, realizing the $0.15 spread as a loss. While that may not seem like a big deal, 15-cents here and 15-cents there and pretty soon you're talking about real money.

Some options have much wider spreads that must be dealt with. One of the current OIN Call plays, SRCL is currently trading near the $73 and differs primarily (in terms of trading activity) from IBM in that daily volume is much lower. IBM trades nearly 10 million shares per day and ATM options tend to trade several hundred to several thousand contracts per day. SRCL on the other hand, has an ADV of 265K shares and traded just 20 contracts of the JUN-75 Call today. Lower volumes mean wider spreads, pure and simple.

Why? I'm glad you asked! The spread is the market maker's reward for taking on the risk of making a market in a particular stock or option. When you buy at the Ask, the market maker will typically buy from another trader at the Bid and then Sell to you at the Ask, pocketing the difference for his troubles. If there is less volume in that particular stock or option, he needs to expand the spread to compensate for the increased risk that accompanies the lower liquidity in that market.

If you want to see some really wide spreads, go take a look at an option chain on the S&P 500 (SPX.X). With the SPX currently trading near $1093, the JUN-1100 Call is Bid at $20.10, while the Ask is $22.10. That is a $2.00 spread and you can see how having to eat the spread can have an adverse affect on your profits. We all trade different securities and therefore deal with different spreads, but we all have to deal with the issue of the spread and the way it impacts our trading results.

One simple solution is to never place Market orders, and instead try to split the Spread. For instance on the SPX option above, I might place a Limit Buy order at $21.10, attempting to cut my spread-related risk in half. We can't begrudge the market makers for taking their cut. Afterall, they have to make a living too! But we can try to trim the edges off of our cost of doing business. So let's say the market maker is feeling particularly magnanimous and gives me the option at $21.10. Then just as the SPX gets going in my favor, a sell program hits the S&P pits and I decide to exit the trade with the Bid at $23.50 and the Ask at $25.30.

Do I attempt to split the spread again, hoping to get out with a fatter profit or do I just place an order at the Bid? Decisions, decisions...

I take a hybrid approach, owing to the fact that I always trade multiple contracts when I take a position. I leg into the position on the entry and then leg out on the exit. It doubles my commission costs, but gives me more flexibility in terms of managing my entries and exits. When I have decided that I want to exit the position, I will split my position in half. The first half I will place a Limit Sell order midway between the Bid and the Ask, while I will place a Limit order at the Bid for the remainder of the position. That way I know I'll at least get out of half of my position and can then target more favorable pricing on the remainder.

You might wonder why I also leg into positions at the entry. Have you ever found a solid trade that you wanted to enter and placed a Limit order, trying to split the spread, and never gotten filled? Well, I have. And it can be particularly maddening when you are right about the play and you end up sitting there watching it run, unwilling to chase the market higher. So we apply the same solution I described above, only in reverse.

Once I have decided to take a position, I'll place a Limit Buy order for half of my desired position size at the prevailing Ask and then will place a Limit Buy for the remainder of the position between the Bid and the Ask. Best case, they will both be filled and I will have slightly reduced my cost basis. Worst case, I will only be filled on half my position before the market starts moving in my favor.

Over the years, I have found this strategy to give me a good balance between grabbing the optimum entry point into a play and preventing the situation where I watch a play run away without me. Or even worse, being too stingy on an exit price and having the play start moving sharply against me, all because I was unwilling to give the whole spread to the Market Maker. Hopefully this discussion gives you some fresh ideas for working the spread, so that you can continue to improve your trading results.

Have a great week!

Mark

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