Follow me at @Alice Arnault Less fluff and more substance
Always look far and wide
5 to 10 percent
A good rule of thumb for a "reasonable" bid-ask spread on options is to look for spreads that are no more than 5-10% of the option's ask price.
For highly liquid options, such as those on widely-traded stocks or ETFs, you may find spreads much narrower, sometimes just a few cents.
However, for less liquid options or options with less trading activity, you may find wider spreads.
In such cases, be cautious when trading these options, as the spread could significantly impact your profits.
Additonal costs from spreads
If the spread is higher than 10% of the ask price, it may be considered too high, and you should evaluate whether the trade is worth the additional cost.
Why is there an additional cost?
Suppose you want to trade an option on stock XYZ. The option has a bid price of $2.00 and an ask price of $2.20, resulting in a bid-ask spread of $0.20 (or 20 cents).
Case 1: Narrow spread
If the spread was narrower, say the bid price was $2.10 and the ask price was $2.15, then the spread would be $0.05 (or 5 cents). In this case, if you wanted to buy the option, you would pay $2.15, and if you wanted to sell the option immediately, you would receive $2.10. The difference of 5 cents ($2.15 - $2.10) represents your trading cost.
Case 2: Wider spread
Now, let's consider the original spread of 20 cents, with a bid price of $2.00 and an ask price of $2.20. If you buy the option at the ask price ($2.20) and want to sell it immediately, you can only sell it at the bid price ($2.00). In this case, the difference of 20 cents ($2.20 - $2.00) represents your trading cost.
Comparing the two cases, it's clear that the wider bid-ask spread (20 cents) results in higher trading costs than the narrower spread (5 cents).
Active traders are more affected
This increased cost can eat into your potential profits, particularly for short-term or active traders who frequently enter and exit positions. Therefore, it's generally preferable to trade options with narrower bid-ask spreads to minimize your trading costs.
Comments