When I was a market maker in options, my job was to make bid and ask prices. To make money, I made my bid prices low enough and my ask prices high enough so if I bought or sold a respective option at a given price, I might squeeze a profit on the trade. Of course, if my markets were too “wide”—with the bid and ask too far apart—no one would trade with me. That was a balance I had to strike. Often bid/ask options spreads widen out when higher volatility strikes the underlying stock or index—like if a stock moves $1.00 a day when it usually moves $0.20.
The reason the bid/ask options spread gets wider has to do with how market makers manage trades. Market makers don’t speculate on where a stock price will go. They usually keep the delta of their positions close to zero. They do that throughout the day by trading stock against the options they buy or sell. If a customer sells 10 calls, the market maker buys those calls and has to hedge the calls’ long delta.
Consider a 0.30 delta call. The market maker would sell 300 stock shares to offset the long 300 deltas from the 10 calls bought. The market maker is tracking the stock price to determine where she can fill it. If the stock is trading a lot at a given price, and not moving much, she’s confident she can execute a trade at or near that price. She’ll make narrower bid/ask options spreads to be more competitive with other market makers.
But if the stock price is moving and volatile, the market maker is less confident she can execute the trade at the desired price. She might not get filled until the price has moved away. She has to factor the slippage from her potential stock trade into the bid/ask spread of the option.
Buying the option at a lower bid price or selling the option at a higher ask price lets the market maker get a slightly worse fi ll on the stock hedge and still make some money on the trade.