The bid-ask spread is the difference between the bid price and the ask price. The ask price is the price that buyers are willing to buy a certain security for while the bid price is the price at which a seller is willing to sell a security at.
To facilitate trading around the security, the market makers require a fair bid-ask spread to be established so that they can profit from the facilitation of trading and also to compensate them for the risk that they take on.
A hypothetical example
TTT Corp December 25 call is trading at a bid price of $1 while its ask price is $1.25. Theoretically, the market makers can buy at $1 from sellers of the security and then sell it at $1.25 immediately, thereby making a 25 cents spread from the sale. In this way, trading around the security is also facilitated.
The option buyer however, has to buy the option at a price of $1.25. If he chooses to sell the option immediately, the buyer will lose :
$0.25 x 100 = $25
Hence, the buyer will lose $25 per option contract while the market maker will earn $25 per option contract.
This bid-ask spread compensates the market makers for the risk that they take on to facilitate the ease of trading. Naturally, the greater the risk that the market makers have to take, the greater the bid-ask spread.
Wide bid ask spreads on illiquid stocks
Let us examine a real life example here. Ashford Hospitality Trust Inc is a publicly traded company and it is an optionable stock. We have here the option chain for the month of November. Let us look at the November put with a strike price of $10. The bid price is $2.65 while the ask price if $3.40. This represents a $0.75 spread.
Also do observe the November 12.5 strike. Its bid price its $4.90 while its ask price is $6. This represents a spread of $1.10. This means that an option buyer who buy at $6 and wants to sell immediately would make a loss of $110 per contract. As such the price of the security, that being the price of Ashford Hospitality Trust Inc in this case has to move significantly in order to the options trader to close out the position at a profit. This is an issue with highly illiquid securities that option traders should consider.
The market cap of between $400 million to $500 million and the stock’s average traded volume is approximately 900,000.
Narrower bid-ask spreads on liquid securities
This is an options Chain for Coca Cola Co. Let us look at the February 43.5 put. It’s bid is $0.72 while the ask is $0.75. Its spread is only $0.03.
For the February 44 put, its bid is $1.03 and the ask is $1.09. This represents a spread of $0.06.
Coca Cola Co is a company with a market capitalisation of 185 billion at the time of this writing and its average volume is 14.65 million. Hence Coca Cola is a more liquid company than Ashford Hospitality Trust Inc.
The reason why it has narrower bid and ask spreads is because it is a more liquid security than Ashford Hospitality Trust Inc.
Summary
Option traders must be aware of illiquid securities as the options on these securities tend to have wide bid-ask spreads which reduces the probability of profitability. Because the bid and ask spreads are so wide, it is important that the trader calculates his maximum profit potential relative to the wide bid and ask spreads. If the bid and ask spread is $0.75 but the position can only bring in a potential profit of $1, then the trade may not be worth the risk. But if the bid and ask spread is $0.75 and the trade is expected to bring in a potential profit of $5.00, then the trade may be worth the risk.
Read: Liquidity & Low Priced Common Stocks Have An Arithmetic Advantage
Read also: How To Get A Better Buying & Selling Price Of An Option By Narrowing The Bid-Ask Spread
Read also: Learn to read and understand options chain as bid and ask spreads are reflected in the option chain of an optionable security.