The Bid-Ask Spread is the amount by which the Ask exceeds the Bid. This is essentially the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it.
For example, if the bid price is $6.50 and the ask price is $6.90 then the “bid-ask spread” is $0.40.
The size of the spread from one asset to anotherwill differ mainly because of the difference in liquidity of eachasset. For example, currency is considered the most liquid asset inthe world and the bid-ask spread in the currency market is one of thesmallest (one-hundredth of a percent). On the other hand, less liquidassets such as a small-cap stock may have spreads that are equivalentto a percent or two of the asset’s value.
We all know that typically we buy at the Ask and that we sell at the Bid.
Well, here’s something that we need to apply as options traders, particularly when we’re trading straddles and strangles.
Always try to trade INSIDE THE SPREAD …
Now what do we mean by this? Well, if the Bidfor a straddle is 6.50 and the Ask price is $6.90, the MID-PRICE is $6.70, and that’s where we need to try to get our trade filled.
So, how do we do that?
Simple. We state in our order that we buy the straddle (or strangle) with a LIMIT ORDER at $6.70.
This means that our trade will be filled at $6.70 or cheaper.
Brokers like optionsXpress will guarantee you thebest fill in the market place. For us, when we buy, the best fill isthe cheapest fill. When we’re selling the best fill is when we getmore! So it’s always worth trying to trade INSIDE the Bid-Ask spreadwith a LIMIT ORDER like this.
Remember there are 2 components to high yields:
1. A big move
2. Keeping the initial cost down.
Let’s look at the example below:
Let’s look at the 70 strike straddle.
We see that the call is priced at 5.10 – 5.40 and the put is priced at 4.10 – 4.30.
So the straddle is priced at 9.20 – 9.70.
The mid price of the straddle is 9.45, so asensible area to place a limit order for this trade would be 9.50. It’s slightly nearer the Ask, which therefore gives us a better chanceof a fill, but it’s still well below the Ask. A limit order of 9.40would be more aggressive but would give us less chance of a fill.
Now let’s look at the 65 – 75 strike strangle:
The 65 strike put is priced at 2.20 – 2.30 and the 75 strike call is priced at 3.10 – 3.20
So our strangle is priced at 5.30 – 5.50.
This is a nice, tight spread, but we’d still tryto get it at 5.40, and because the spread is already tight, we’re quitelikely to get a fast fill at 5.40.
And that’s how to trade straddles inside the Bid-Ask Spread!