Wide bid-to-ask spreads in options are part of the deal during volatile markets. The question to ask is, Why? Blame it on the market makers.
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.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2020 TD Ameritrade.