Executing an Options Trade: Navigating the Bid/Ask Spread

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.

Driving the Point Home: Every Transaction Has a Bid/Ask Spread 

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.

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.

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. Some traders (not naming names here) have been known to watch the crude oil and gas futures market to help them time their purchases. 

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.

Defining the Bid/Ask Spread

Each 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 any transaction, the seller receives the bid price, and the buyer pays the ask price. 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.”

It’s the same basic structure in the financial markets. Want to buy or sell a stock? The bid and ask prices are posted. Want to buy or sell a call or put option on that stock? Those are posted as well (see figure 1 below). But remember: These prices move quickly—typically faster than the eye can see.  

Bid, Mid, or Ask—and the Order Types That Support Them 

To fully understand the dynamics of bids and offers, you first need to understand a few terms, and a couple of the basic order types. Here’s a quick rundown:

• Crossing the bid/ask. To buy an option, you need a seller willing to match up to your price. Hitting a bid or lifting an offer is known as crossing the bid/ask spread.  
• Market order. This is to buy or sell immediately at the next available price. But note: If you see an offer on the screen and place a market order, you’re not guaranteed that price. For more liquid contracts, it’s generally pretty close, but sometimes markets are less liquid and some products (and complex orders such as multi-leg spreads) are inherently less liquid. This brings us to the next term.
• Slippage. This is the difference between where you might expect to get filled and the price at which the order is executed.
• Limit order. Want to buy or sell at a specific price (or better) to potentially limit the amount of slippage in your order? Name your price with a limit order. But note: The risk of not getting filled—even if it looks like you should be filled—is always there with a limit order. Again, for a trade to commence, the bid/ask spread must be crossed by one of the two parties to the trade.  
• Mid-market (or “mid price”). Say you’ve got your eye on an option to buy, and the spread is $0.10 wide. The mid price is halfway between the two. If you want a reasonable expectation of getting filled in short order, you might need to place an order somewhere between the mid and the offer (see figure 2). Market makers—who often take the other side of the order—are looking for a small theoretical advantage in order to trade. That’s how they get paid to take the risk and keep markets in line and liquid.
• Price improvement. Although price improvement can be a general term that means “getting a price better than the bid/ask spread you see on the screen,” there’s a more formal description as well. Brokers use order routing technology to help ensure best execution, and they monitor the data closely. Learn more about price improvement and execution quality at TD Ameritrade.   

Back to the Driving Analogy

Buying a car? You could lift the offer (the 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.) In the end, you’ll either cross the bid/ask with the dealer—hopefully after decent price improvement on the dealer’s part—or you’ll cancel your order and walk away.

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 wait 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 plenty of company in the real world of transactions. And 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.