by Rob Roy

The bid and ask prices are known as the “natural” prices of the option.  The bid price shows what the option may be sold at right now, while the ask price shows what the option may be bought at right now.  To explain this, think of the bid price as the wholesale price, and the ask price as the retail price.  It would be great to be able to buy options at the wholesale (bid) price and sell them at the retail (ask) price.  However, the off-floor trader (anyone who does not work at an exchange), cannot do this.  The bid and ask prices represent at what point the option can be bought and sold right now.

Trading off these prices alone would be like going to a car dealer, and not negotiating price.  If you walked into the car dealership you will see the “sticker” price on the car.  No one pays the sticker price.  They always attempt to negotiate.  This is also done when selling a car to the dealer or “trading-in” a car to them.  Think of the first price they offer you for your trade-in as the bid price of an option, and the sticker price on the new car as the ask price of an option.  Even if you were trading the same exact car to the dealer as the one you want to buy, the dealer would give you two different prices.  The reason for this is that they have to have room to make a profit, or it is not worth it for them to do business with you.

The floor traders, or market makers (the traders working at the exchange), are like car dealers.  For them to trade options, they want room to make a profit if they buy the option from you, as well as if they sell the option to you.  The options have a “fair” price based on the option-pricing model.  The market maker wants to sell the option to you for more than fair price, and buy it from you for less than fair price.  What they have done is create a market for prices at which they are willing to trade with you.  Bid is the price they are advertising they will buy from you (you would be selling to them), and the ask price is the advertised price at which they will sell to you (you would be buying from them).  Before doing business with them it would be smart to know what the “fair” price of that option is.

Most brokers will show what the “fair” price is in the option chain.  This fair price is often called the “mark” price.  The mark price is a simple calculation of being the halfway point between the bid and ask prices.  The mark price will be the halfway point regardless of how wide the difference is between the bid and ask.  As a trader you want the bid and ask prices to be as close together as possible.  That shows that the options are liquid enough to trade as well as shrinking the chances of overpaying or underselling the option when opening and closing the trade.  Keep in mind that this is a broad stroke explanation of what “fair value” is.  There is another layer of detail when it comes to implied volatility of the strike price, size of the strike prices market, and depth of the strike prices market.

Analyzing the option chain to check that the options bid/ask spread is not too wide is a straightforward approach.  Using the top option chain below, look at the difference between the bid and ask prices for the ATM options.

If the bid/ask spread is less than $0.15 the option is “fairly” priced and liquid enough for trading.  The option chain on the top satisfies that criteria and is ok for trading with the bid/ask spread only being $0.10 wide.

Now looking at the option chain on the bottom, however, has a bid/ask spread over $0.15 which is normal for stocks that trade at higher prices and thus have higher priced options.  If the bid/ask spread is over $0.15 the trader wants to make sure that the difference is less than 10% of the ask price.

Look at the 380 strike put on the right hand side of the bottom option chain.  The ask price is $17.20.  10% of $17.20 is $1.72.  The difference between the bid and ask prices is $1.30, which is less than $1.72 (10% of the ask price).  If the bid/ask spread was over that amount, it could show that the options are unfairly priced, there is not enough volume, or that there is something happening with that stock.  An option trader would want to stay away from trading those options with the wide bid/ask spread.

To every rule there are always exceptions.  There are several stocks that have bid/ask spreads that are too wide to meet these criteria, yet trade enough volume to still be usable.  This is usually the case with large Indexes as well.  It is recommended to keep to these “fair” pricing guidelines until you, the trader, are very experienced with options to avoid troubling pricing issues.  This is most important when a trade is in need of being closed quickly.

The option chains above also have the “mark” price column added into the option chain.  When creating the price to buy the Strangle to open, or sell the Strangle to close, most often the trader will use the “mark” price to create the price for the trade.  With the liquidity and option volume being traded nowadays, with patience most trades can be filled at these prices.  If a trader was not getting filled on the opening order for their trade, they might consider raising the price they are willing to pay to enter the trade by $0.05 or $0.10.  The same concept could be used when exiting a trade by lowering the price they are willing to sell it to close by $0.05 or $0.10.  Be cautious as a new trader that you are not too anxious to get the trade filled and change the price too often.  This could cause you to get caught up in what is known as “whipsaw” moves in the market.  There is not a rule or general guideline how long a trader should wait before changing the price they are willing to take for the trade.  Learning this will come from experience in trading real option trades.