For options traders, the importance of effective order execution can not be overstated. A discount of only a few cents per transaction can substantially increase portfolio returns on an annual basis. Unfortunately, someone who does not understand the mechanics of the bid-ask process will likely be content with fills that are much less favorable than those achieved by a more knowledgeable participant. This tendency directly contrasts that of experienced market players, who know how supply and demand affect the published quotes in an exchange-based system, and who use this insight to attain the best possible prices in every trade.
When a trader requests the price of a specific option, he will receive two quotes; a bid price and an ask price. The bid represents the current price at which he can expect to sell the option, which is also the highest amount someone is offering to pay. The ask denotes the present cost to purchase the option, or the lowest price at which someone else is willing to sell. The difference between these prices is often referred to as the bid-ask spread.
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The first question we must answer is, "Why is there a bid-ask spread?" Most people know it has something to do with supply and demand but that is only part of the equation. In truth, the difference in price between the bid and ask is necessary to help compensate market-makers for maintaining liquidity and to offset exchange-related fees associated with the transaction. Remember, the essence of a liquid market is that someone is ready to buy or sell significant quantities of a particular issue at any time. When specialists provide this service, they try to buy options from the public at a slight discount (the bid price) and sell options to the public at a premium (the ask price). Although that concept is relatively simple, the reasons for the different sizes of bid-ask spreads is far more complex. In fact, the "spread," as it is commonly called, is influenced by a number of factors including volume, demand, and supply. To understand this process, you must first learn what determines market prices and how buyers and sellers are matched to facilitate trade execution.