Lesson Overview

Bid-Ask Spread Defined

The stock market is the biggest and most efficient live auction on the planet. But even within this huge market there are very illiquid markets for particular stocks that aren't as popular as say some of the big names; AAPL, GOOG, TWTR, etc. Recognizing and understand how the bid-ask spread effects the prices you pay for an option and the "slippage" in the market is important as we continue to build on our understanding as to why trading liquid underlying is important. Wide markets with regard to bid/ask spread can be extremely detrimental to your success and most traders fail to recognize it before it's too late.

Show Video Transcript +

In this video, we're going to quickly cover the bid/ask spread. This seems to be a little bit of a hangup for some people, but it's very easy to understand once you get the basic concepts.

We all have to remember that the stock market is a huge live auction. People are always and constantly placing bets. Placing bets to buy and placing bets to sell. It's just a huge auction.

Then when they agree on a price, then a transaction occurs. Remember that a bid is just the highest price that someone is willing to pay. There may be other prices in the market but, at the time, the bid is the highest price that someone is willing to pay for security or an auction.

The ask is the lowest price that someone is willing to sell. Once these two people meet, if their prices agree, then a transaction occurs. These are, as of the moment, that you pull the recent quotes and they change from second to second.

Again, it's a live auction, so the bid/ask spread is continuously moving back and forth. The reason that you have spread is so that there's no arbitrage in the market, which means that there's free money.

You can't just go out and buy security and immediately sell it right back to the market without having any risk whatsoever. At all times, you are never going to buy security for more than you can sell it right back to the market.

You have to have some market movement before you can make any money. That is why there's spread in the bid/ask spread and also, for the exchanges and the brokers to mix their money as well.

If it's confusing, think about real estate when you talk about the bid/ask spread. Buyers in real estate will place a bid to purchase your house. They will, again, for example, say that they want to purchase the house for $100,000.

As the seller of a house, you might have an asking price of $105,000. Again, your two prices don't exactly meet right now. There is a bid/ask spread of about $5,000. It's kind of open land where you have to negotiate.

In options pricing, that bid/ask spread is then turned into a last transactional price. Again, the bid/ask to spread the same, what somebody's willing to buy, what somebody's willing to sell.

In this example for this December 380 contract here, you can see that the bid/ask spread between 1,435, which is the bid and the asking price is 1,450. That doesn't mean that you have to buy it at 1,435 or you have to sell at 1,450 or whatever the case is.

I like to look at the column in your pricing table that says, "Last price," or, "Last X," or, "Last exchange, last transaction." That gives you an idea of where people are landing in between this bid/ask spread.

You can see here that the actual last trading price for this 380 December contract was 1,440, which is kind of right in the middle range there. If you're buying, don't feel like you have to buy at 1,450.

If you're selling, don't feel like you have to sell at 1,435. You can get a little bit higher price. Using the last price is usually the best for bid/ask spreads. With any options, trading marketer or any stock, it's important to understand that the tighter the spreads are, meaning the tighter the distance between these two, the better.

If you get into some of these illiquid markets, where there's not a lot of volumes and not a lot of activity, then you're going to see spreads that are fairly wide. It's not uncommon to see 50 to even a dollar spread between the prices.

Again, you want to focus on those options that have a lot of open interest, a lot of volumes and, therefore, a very tight bid/ask spread, which means that the market is very efficient, it's liquid, you can easily get in and out of the contract with minimal risk.

As always, I hope you guys enjoyed this video and thanks for watching. Take a second to share this video right below here using any of the social network links.

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