The Bid-Ask Spread Explained
In this guide, you're going to learn about the bid-ask spread, which is a crucial liquidity metric that should be examined before trading any stock or option. If you'd like, you can skip to a particular section by clicking on the section title.
Before trading any product in the market, it's crucial to gauge the hidden costs of entering and exiting a position in that product. The bid-ask spread can be used to assess the cost of trading a particular stock or option.
Before discussing the bid-ask spread, we need to talk about what the "bid" and "ask" prices are. The following visual explains what the bid and ask prices represent:
When trading a share of stock or an option, you can get filled on your order immediately if you sell at the bidding price or buy at the asking price. Therefore, the bid-ask spread tells you how much money you would lose if you purchased something at the asking price and sold it at the bidding price (sometimes referred to as "slippage").
In this case, you'd have to buy at $3.50 or sell at $3.00 to get filled immediately. When purchasing at the ask and selling at the bid (or vice versa), the corresponding loss will be $0.50, which translates to $50 for 100 shares of stock or 1 option contract.
Ideally, you want to lose as little as possible when entering and exiting a position, which means trading products with a narrow bid-ask spread is preferred.
As an example, let's look at some hypothetical bid-ask spreads for various trading products:
Shares of Stock
If a trader wanted to purchase a share of stock instantly, they would have to pay the asking price of $100.03. To immediately get out of the position, they would have to sell at the bid price of $100.02. As you can see, the loss on this transaction is $0.01 per share (not including commissions). With 100 shares, the loss would be $1 ($0.01 x 100). A $0.01 bid-ask spread is the best-case scenario and is an indication that a product is actively traded.
Now, regarding the call option, the asking price is $1.20 higher than the bid price, which means a trader would lose $120 from just buying the call at the asking price of $6.30 and selling the option at the bidding price of $5.10. Trading products with a bid-ask spread this wide is clearly not advised.
Lastly, the put option has a bid-ask spread of only $0.05, which is considered to be a narrow spread. In the case of buying at the asking price and selling at the bidding price, a trader would only lose $5 per contract.
When trading shares of stock, the bid-ask spread will often be a few pennies wide. However, a majority of stocks have illiquid options with wide bid-ask spreads. So, be more aware of the bid-ask spread when transacting in the option markets, and try to only trade options with bid-ask spreads less than $0.10, as it will save your trading account from "hidden" costs that can accrue to massive amounts over time.
At this point, you know and understand the implications of the bid-ask spread. Next, we'll quickly discuss which options tend to have the widest bid-ask spreads so you can avoid trouble when trading options.
Which Options Have the Widest Bid-Ask Spreads?
Options with strike prices further away from the stock price typically have wider bid-ask spreads.
To visualize this, we plotted a snapshot of the closing bid-ask spreads for calls and puts on SPY (S&P 500 ETF), which is an ETF that has one of the most actively traded option markets. We used options from early 2016 that had approximately 60 days to expiration:
As we can see here, in-the-money calls and puts have the widest bid-ask spreads (approximately $0.50 for the deep-in-the-money options). The options with the narrowest bid-ask spreads are the at-the-money options (strike prices near $205), and the out-of-the-money options. However, it's worth noting that the out-of-the-money options have narrower bid-ask spreads because the option prices are cheaper (a $0.05 option couldn't have a $0.50 bid-ask spread).
Bid-Ask Spreads of Long-Term Options (LEAPS)
Now, let's look at the bid-ask spread of the same strike prices in the expiration that's nearest to 365 days to expiration:
Right off the bat, we can see that the at-the-money 365-day options have a bid-ask spread near $0.20. The same options with 60 days to expiration had bid-ask spreads near $0.05. Regarding the in-the-money options, the bid-ask spread is slightly narrower in the 365-day options, which could be explained by higher trading volume in the long-term in-the-money options. Either way, it's clear that the minimum bid-ask spread is four times wider in the 365-day options than in the 60-day options.
Spreads vs. Market Volatility
As mentioned previously, bid-ask spreads widen when market volatility picks up. To illustrate this, we plotted the average at-the-money bid-ask spread of SPY options on each day between August 3rd, 2015, and September 18th, 2015. We used the September 2015 expiration cycle:
As we can see, there's a clear relationship between market volatility (as indicated by the VIX Index) and the bid-ask spreads of options on SPY. While only SPY is used as an example in the visual above, the same concept applies to other stocks in the market as well.
In this example, it's important to note that the bid-ask spread increased from $0.025 to $0.15 as market volatility increased, but these were the closing bid-ask spreads. When the market opened on August 24th, the bid-ask spreads of SPY options were between $2.00 and $5.00 because the market had opened down 5%. However, the spreads narrowed throughout the day.
So, if you find yourself in a situation where the market is going to open significantly lower than the previous day, expect the bid-ask spreads to be wide in the first couple hours of the trading session.