Are you planning on trading options? Here’s what traders and investors should know about the difference between the bid versus the ask spread, order types, and slippage.
If you trade options—or stocks, futures, or anything really—you know that navigating the holding period is the hard part. You have your exit target in mind, but you watch the ebb and flow of the market and think (hopefully not obsess) about when and where to pull the trigger.
The last thing you need is logistical concerns about those bids and offers (aka the bid and the ask, or simply the bid/ask spread).
Need a short course on the bid and ask in options? Here you go.
Consider these auto-related transactions:
Buying a car. When you buy a car, do you look at the sticker price, sign your name, and drive away? Of course not—that’s the starting point of what will be a (sometimes unpleasantly enhanced) negotiation. Their price is an asking price, and you go in with your price, which is a bid price.
The drive-through window. Say you want to celebrate your new purchase with a burger and fries. When you drive your new wheels to the pick-up window, the price you see is the price you pay. However, if you think the price is too high, you may go somewhere else.
Gassing it up. Unless you bought one of those spanking-new electrics, you’re going to need gas. For that, you might shop around a bit or use an app to help you find the best price. When you cruise gas stations looking for a better price, you’re combing through the ask prices because you probably have a “bid” price in mind you want to pay.
Selling the car. Eventually the day will come when it’s time to part ways with that set of wheels. You can either sell it as part of a trade-in (and take the price the dealer’s offering), or you can try to sell it on your own. In that case, you’d post it on your favorite platform—at your requested price—and wait for a bid. You might accept the first one you get, or you might use any bids as the starting point for a negotiation.
Pretty straightforward, right? If you follow, you can make the jump to options bids and offers.
Some of the above transactions involves bids and offers and, as we’ll see below, different ways to navigate the bid/ask spread. What do the terms mean? Let’s break them down.
In a publicly traded financial instrument transaction, the seller looks at what other sellers are asking for and where buyers are bidding and then decides what they should ask for. A buyer, on the other hand, looks at other buyer’s bids and seller’s offers and then decides where they will bid. Sticking with the car analogy, suppose you sell your car at auction. Well, it’s ultimately sold to the highest bidder, or at the “bid” price. But if you intended to buy a car, you may approach the owner and inquire, “How much are you asking?” And then pay that “ask” price.
Similarly, the financial markets are structured with bid and ask prices. With financial quotes, the bid and ask are created by real orders from the public. And while market makers can buy stock at the lower bid and sell stock at the higher ask, filling market orders this way all day, the exchanges and market makers can’t decide the bid or ask prices. Instead, the bid and ask are created by traders sending in limit orders. So while market orders to sell fill at the lower bid and market orders to buy fill at the higher ask, many of those trade executions fill the existing limit orders of other traders.
You can see bid and ask prices for a stock’s call and put options listed on the thinkorswim® trading platform (see figure 1). But remember: These prices move quickly—typically faster than the eye can see.
To fully understand the dynamics of bids and offers, you first need to understand a few terms and a couple basic order types. Here’s a quick rundown:
FIGURE 2: SAMPLE ORDER TICKET. When you pull up an order ticket on thinkorswim, you have choices in the order type as well as the execution price. Chart source: The thinkorswim platform. For illustrative purposes only.
So, if you’re buying a car, you could buy at the ask or sticker price, but you’re likely putting in a limit order somewhere near your perceived fair value. (Yes, in car buying and trading, you need to conduct your research and due diligence.)
At the burger joint, there’s no slippage. You don’t buy the $6 value meal, pull up to the window, and have them tell you your order was filled at $6.50. But there might be slippage on your way to the pump. The price data in your gas app might be stale, or if you saw the sign out front in the morning but waited until the afternoon to fill up, you might see the price has changed.
And when selling a car, you can either hit the dealer’s bid on a trade-in (that’s pretty much a market order) or you can list it for sale at your limit price and maybe look for a bid to come in around the mid-price.
So really, navigating the bid/ask spread in trading has a lot of similarities to other transactions in our lives, but also some important differences. Let’s be thankful that the bid/ask spread in your options trade doesn’t require a negotiation of floor mats, seal coats, or extended warranties.
While options trading involves unique risks and is definitely not suitable for everyone, if you believe options trading fits with your risk tolerance and overall investing strategy, TD Ameritrade can help you pursue your options trading strategies with powerful trading platforms, idea generation resources, and the support you need.
Learn more about the potential benefits and risks of trading options.
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