Articles and Updates
August 2024
Understanding the Bid and Ask Prices for Options
Option prices are driven by all market participants, whether that is a bank, a fund manager, a market maker, or an individual investor.
The process of buying or selling an option begins when one of these market participants submits an order, such as a market order or a limit order, to their brokerage firm. The order then flows from the brokerage firm’s platform to an exchange. Once an exchange receives the order it is sorted by class, series, bids, offers and the desired execution price. Depending on the price, one of three outcomes could take place:
The data in a typical option chain is constructed by Options Price Reporting Authority, LLC (“OPRA“) by collating prices from all options exchanges into the best bid and offer, also known as the National Best Bid and Offer (“NBBO”).
The number of active buyers and sellers generating bids and offers is often considered a measure of order flow, and the number or size of the bids and offers is viewed as an indicator of supply and demand. The bid size shows the demand to purchase a particular option at a given price while the ask size shows the supply of options for sale at the ask price. If the bid size is greater than the ask size, this may be an indication that the demand to buy those options is greater than the supply to sell the option.
When viewing an option chain quote, the spread between the bid and ask is as notable as the bid and the ask prices themselves. Investors may wonder whether trading volume drives the bid-ask spread or if the bid-ask spread drives trading volume. Although both ideas have merit, many factors can impact either narrow or wide bid-ask spreads, including economic events, anticipated news such as earning announcement, perceived trading risk, and competition of market participants. Even the width of the underlying asset’s bid-ask spread can impact the option’s bid-ask spread. For instance, a wide underlying bid-ask width may produce a wide bid-ask width in the corresponding options
Besides identifying the specific events that may impact the bid-ask spread, another consideration is the impact the bid-ask spread may have when entering and exiting a position. Depending on the bid-ask spread, and order type selected, the order may be exposed to what is known as slippage.
Investors generally choose between two order types with options. One is a market order, which is typically executed on the quoted offer price for a buy order and the quoted bid price for a sell order. Market orders may have a quick fill turnaround time, but they also can have a greater chance of experiencing slippage. Meanwhile, the other type of order, a limit order, may mitigate slippage. Still, although a limit-order involves the investor setting an execution price, it also requires the understanding that the order might not be executed at all if the limit price is never reached. The investor will need to consider these trade-offs on an individual basis.
For investors, developing an understanding of the bid-ask dynamic, using a balanced analysis of prices, the size of the bid-ask and the width of the spreads, may help determine the right order type for their projected outcome
The process of buying or selling an option begins when one of these market participants submits an order, such as a market order or a limit order, to their brokerage firm. The order then flows from the brokerage firm’s platform to an exchange. Once an exchange receives the order it is sorted by class, series, bids, offers and the desired execution price. Depending on the price, one of three outcomes could take place:
- One scenario is that the order is executed, and the fill is reported back to the investor.
- Another possibility is that the order may be placed in a queue based on the investor’s price, awaiting execution.
- Another potential outcome is that if the order improves either the bid, by being the highest price a buyer is willing to pay for the option, or the offer (also known as the ask), by being the lowest price where a seller is willing to sell, it is displayed in the option chain and made available to all traders.
The data in a typical option chain is constructed by Options Price Reporting Authority, LLC (“OPRA“) by collating prices from all options exchanges into the best bid and offer, also known as the National Best Bid and Offer (“NBBO”).
The number of active buyers and sellers generating bids and offers is often considered a measure of order flow, and the number or size of the bids and offers is viewed as an indicator of supply and demand. The bid size shows the demand to purchase a particular option at a given price while the ask size shows the supply of options for sale at the ask price. If the bid size is greater than the ask size, this may be an indication that the demand to buy those options is greater than the supply to sell the option.
When viewing an option chain quote, the spread between the bid and ask is as notable as the bid and the ask prices themselves. Investors may wonder whether trading volume drives the bid-ask spread or if the bid-ask spread drives trading volume. Although both ideas have merit, many factors can impact either narrow or wide bid-ask spreads, including economic events, anticipated news such as earning announcement, perceived trading risk, and competition of market participants. Even the width of the underlying asset’s bid-ask spread can impact the option’s bid-ask spread. For instance, a wide underlying bid-ask width may produce a wide bid-ask width in the corresponding options
Besides identifying the specific events that may impact the bid-ask spread, another consideration is the impact the bid-ask spread may have when entering and exiting a position. Depending on the bid-ask spread, and order type selected, the order may be exposed to what is known as slippage.
Slippage is the difference between the expected trading price and the actual traded price. Even though the word “slippage” may have a negative undertone, the trade outcome can result in a more favorable price (positive slippage). A worse-than-expected price would be negative slippage. Either way, wide bid-ask spreads may have more risk of slippage, whereas a narrow bid-ask spread may be less prone to slippage. Selecting the right order type that fits an investor’s specific risk tolerance can reduce slippage, but there are trade-offs to consider. |
For investors, developing an understanding of the bid-ask dynamic, using a balanced analysis of prices, the size of the bid-ask and the width of the spreads, may help determine the right order type for their projected outcome
Key Takeaways
- When viewing an option chain, the bid is the highest price an investor is willing to pay, and the ask is the best price at which an investor is willing to sell.
- The bid size and ask size is an aggregate number of option contracts available at those prices.
- Bid-ask size can be used to gain insight into the supply and demand of options.
- Slippage is the difference between the executed price of an option and the perceived theoretical fair value of that option. Slippage can be positive or negative.