Hey everyone. This is Kirk here again from Option Alpha and in this video, we are going to walk through the bid/ask spread as it relates to option contracts. And this will be a really important video because understanding the bid/ask spread is really important to getting a gauge of both the depth of the market and the liquidity of a market and the premiums that you’re going to need to overcome in a spread in order to make money on a position. The first thing I want to talk about in the bid/ask spread is basically define what it is, so that you understand how the bid/ask spread works and why it gets its different names. The first thing that we have to look at is the ask price of an option contract. I have a couple different prices here on this timeline and it’s a vertical timeline of different prices, a low price of $2.50, a kind of middle-of-the-road price of $2.55 and then a higher price of $2.60. What essentially happens is that the lowest price that somebody is willing to sell a option contract at or a security at ends up being the ask price. It’s a little bit complicated, but again, I’ll say it slower so you understand. It is the lowest price that someone is willing to sell that particular option contract or security for. There might actually be somebody who is willing to sell the contract for $2.61, but if there’s somebody who is willing to sell the contract for $2.60, that is the lowest asking price that someone is offering. Now, on the other end, you have the bid price and the bid price is all the way down here and it is the highest price that someone is willing to buy the security for right now. Now, again, somebody might be willing to buy this security for $2.49, but if somebody else is willing to buy it for $2.50, then that becomes the bid price. It’s the highest price that someone is willing to buy the security for. I always think in my mind because I work like this and I think like this, that the B in the bid is equivalent to the buy price. When I think about a bid/ask spread, I always think the bid is the price that somebody is willing to buy the security at and then the ask is what they’re asking if they’re going to sell. If you want to use a real estate analogy, the asking price is what the seller is requesting that they sell their property for, so they list their property for sale for some number and the bid is what somebody is willing to pay for that particular property.
Now, what you will find though is you will find this number in between or was often quoted as being the mid-price and the mid-price is nothing more than just the difference or the middle price of the two bid/ask spread prices. The difference between the bid and the ask price here in this case is very simple. It’s $2.55. It’s just the middle price. Now, that doesn’t mean that that is where transactions will or won’t occur. It’s just giving you a gauge of the middle price or kind of the road in the middle between the two parties that are involved, the person who’s trying to sell the contract and the person who’ trying to buy the contract. Now, the wider that this spread becomes, generally, the more illiquid the market is that you’re trading. And so, what people will often look for… And there’s no perfect gauge to say that if it’s a penny wide or five pennies wide or $.10 wide, that that is liquid enough or not liquid enough. It does depend on the underlying security and shares. But again, the difference between the bid price and how wide that market is relative to the difference between that and the ask price gives us a sense of just the depth of the market. If these two prices are very, very close together, let’s say that it was $2.56 as the asking price and $2.55 as the bid price and the market was truly a penny wide like that, I would say that that is probably one of the most liquid markets out there to be so close and that is because there’s so many people that are pricing these securities that they don’t have to make these wide spreads or differentials, there’s a lot of liquidity to get in and out of contracts. When you start to see markets become a little bit wider, potentially like the main example that we have here, it’s because the markets are illiquid and because it requires a little bit more risk and it has to be priced in effectively at the trade entry for the idea that they may have illiquid market when they need to enter or exit the position later on. And so, generally, what you see is you see really wide markets price that associated risk right at trade entry and people are not willing to come up in their bid price or come down in their ask price because they know that if they get the transaction filled and they now have a position, they may not have an opportunity to get out of that position later on if the markets are illiquid.
There’s couple things that you have to understand about the bid/ask spread on this side here first before we continue moving forward. The first thing you have to understand is that the bid/ask spread always shows best price and what we mean by this is that it’s the best price that’s available in the market right now if somebody is willing to immediately and instantly remove, buy, sell their shares. When it comes to the bid price, for example, this bid price is the best price, the highest price that somebody is willing to outlay to buy the option contract right now and the ask price is the lowest price that someone is willing to sell the contract at right now. Now, again, that doesn’t mean that we will always enter the contract at the bid or at the ask or always at the middle, but it will probably be somewhere between these prices as to where somebody will come to an agreement and say, “Yes. I’ll go ahead and do that transaction with you.” or fill that order on some end. But it’s the best price that somebody is willing to buy and it’s the lowest price that somebody or the best price that somebody is willing to sell it at. The other thing you have to remember, and we mentioned it earlier, is that this is all instantaneously, so this assumes that this is an instant transaction that happens right away. If you were to place an order at the bid or at the ask that your transaction would get filled almost instantly because there’s somebody there waiting for your order to get filled. This also means that if you place an order right in the middle, at the mid-price and you don’t want to go all the way up or you don’t want to come all the way down, then that means that your order will probably sit there for a little bit and this is what creates a little bit of frustration for some traders, is just waiting for these orders to actually get filled when they’re placing orders around the mid. Now, just to be clear, I’m very much a fan of placing orders and starting somewhere around the mid-price. I don’t think you always have to go to the ask or to the bid if you’re getting into or out of a contract. I think it’s important to go to the mid and kind of let market participants come in there and entertain the idea of placing a trade there and potentially get the price that you’re looking to get for a security. But if you were to want to get into an immediate position, you would try to place the order probably at the bid or the ask in order to get an instantaneous fill. The last thing you have to remember is that this is always on best exchange. A lot of option prices and bid/ask spreads in broker platforms will quote a little number or a symbol for the exchange that that price was found on. And so, it’s always trying to pull the best price from the best exchange across all the different exchanges that are out there, so that you have a lot of clarity on where the market it. Maybe the price in the best bid on one exchange gets changed instantly and then it comes back. I mean, it happens very, very fast. If you watch the exchanges and the option contracts, you’ll see that they actually change where the best price is. It’s also why you should place your orders for the best exchange and not necessarily deliberately send an order to one particular exchange versus another.
Now, the last thing that I want to talk about here is this bid/ask spread over time because I think this is a really important concept to understand because it does change as you go through the trading day and it does have an impact or the spread has an impact on your ability to make money in narrow markets versus wide spread markets. First thing you have to understand is of course, this is just a representation of time. As a security is trading through the trading day, say like 9:00 o’clock and 10:00 o’clock and 11:00 and 12:00 and 1:00 in the afternoon, the bid/ask spread is going to change over time for a particular contract that you’re watching and the bid/ask spread price can fluctuate around say some of these ranges in here, say like $2.50 and $2.25 and $2 equal, okay? The bid/ask spread will move around these prices. What you’ll notice is you will notice if you track some of this or if you can chart some of this, you can notice that this bid/ask spread does move and maybe most of the time, keeps a consistent spread in the market. The difference between the ask price and the bid price changes as the market changes or as new information and news and investors start to trade the security, but the spread difference sometimes or most of the time stays the same. There are time periods, however, where the spread differential starts to either widen or contract. In this case, the ask price might be significantly higher during this time period and then it might contract back down to a more normal range or vice versa. The first thing you have to understand here is of course, that the bid/ask spread is not something that is stale or stagnant, that it actually does change and it does move and widen and contract as new information and new people start trading in the market. Now, this is important because this width of the spread as it goes throughout the trading day or as it goes throughout the trading weeks or months, gives you an idea of how easily it is potentially to get into the market and then potentially how easy it is to actually have a profitable trade. What happens is… And this is an important concept. Remember that the ask price is the lowest price that somebody is willing to sell shares at right now. An instantaneous ability to sell shares would have to be in this case, at $2.60. The bid price is the highest price somebody is willing to buy shares right now and obviously, this creates a little bit of disparity in who is going to move first. Are the buyers willing to pay up to the ask price or are the sellers willing to basically lower their price down to the bid price?
When you have really, really wide markets, for example, where the price of the security that I’m willing to buy is down here at $2.25, but the asking price that somebody else is willing to sell their security at is all the way up here at $2.50, this new asking price just really kind of widen out. If I’m willing to get into the position or if I want to get into the position for sure, I might be willing at the time to go all the way up to that asking price and pay $2.50. Now, remember, the highest price before that time period, before I made that jump across the entire spread, the highest price that I and everyone else was willing to pay was $2.25. But for whatever reason, let’s say I want to get into it immediately, place a market order or get into the position and I place it at $2.50 and immediately get filled, well, now, I am a buyer up here at $2.50 and I basically willingly paid that entire differential. But if I want to sell my shares back, now when I sell my shares back, I may only find a buyer that is still willing to pay $2.25. I might had been the only buyer that was willing to go all the way up to $2.50 and pay that price because I valued an instantaneous entry into the market. But now, what happens is I have now accepted all of the risk between my price and the next sequential buyer’s best price which is still $2.25. If I’m willing to hold onto that, I need to have all of these buyers eventually start to move up their bid price and I might have to move down my ask price in order for me to have a trade that gets executed. That becomes a very large gap to fill. And so, this is where you hear things like slippage or like just the bid/ask spreads are too wide because if you have to come near that price or somewhere even close to that price, you don’t maybe have to come at full length of the bid/ask spread. Like in our case here, you can see that maybe the spread was actually all the way up here and I got somebody to come down just a little bit. Whoever was selling their shares here, they were willing to come down and meet me kind of a little bit of the way. Not halfway, not midpoint, but a little bit of the way. But what happens is that becomes such a huge gap to fill that I need a really good move in the right direction in order for me to potentially even get back to breakeven.
Now, let’s say that I wanted to immediately sell back my shares or my contract and I wanted to get out of the position. Well, if the bid/ask spread is still really wide, I can only immediately sell shares to somebody who is willing to buy them at the best price and that might still be down here at $2.25. If I’ve jumped all the way across this bid/ask spread and I’ve paid $2.50 and I realized instantly, I don’t want to be in the position and I want to get out, then I’ve got to go all the way back down to $2.25 and that creates obviously a big loss between those. I paid $2.50 for this option contract, but I sell it right back for $2.25. That is why the bid/ask spread exist, is to prevent people from having this arbitrage instantaneous opportunity without taking on any potential risk. They’ve got to take risk in order to let the contract trade and move and that can still happen pretty quickly, but an instantaneous buy and sell like this creates a losing position for both parties which is why the spread exist to remove this arbitrage opportunity. But when you see tight spreads like this where you have a spread that’s really, really tight, if I’m willing to pay $2.25 and the best person is willing to sell the lowest price he’s willing to sell it to me at $2.56, then I’m okay making that jump. That’s just a penny wide jump. But I’m potentially not okay making such a large jump in a more illiquid asset. And some people do this, but again, just understanding these mechanics really helps you understand why spreads widen and narrow and why they become wider and narrow and hopefully why more narrow spreads and tighter bid/ask spreads are better for you as a trader because it removes the additional risk of having to fill contracts that are illiquid and also close these just monster gaps that occur in very illiquid securities with a wide bid/ask spread. As always, hopefully you guys enjoyed this. If you have any questions on bid/ask spread, please let me know in the comments below and until next time, happy trading.
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