Bid-Ask Spread | Understanding Liquidity Part 1


The bid/ask spread is the difference between the lowest price the market is offering to sell an underlying and the highest price the market is willing to buy it at.

The bid price is the highest price the market will currently pay for an underlying.

The ask price is the lowest price the market will currently sell an underlying.

Since you are trading with the market, the bid price is the price you naturally sell an option at, and the ask price is the price you naturally buy an option at. When buying and selling options, you may hear the bid or ask referred to as the “natural price”.

apple-bid-ask

We calculate the difference between the two prices to come up with the bid/ask spread.

If the bid price on Apple stock ($AAPL) is currently $127.43 and the ask price is $127.45, the bid/ask spread is $0.02 (ask price $127.45– bid price $127.43 = bid/ask spread $0.02).

What that means is the highest the market is currently offering to buy a share of Apple is $127.43 and the lowest the market is offering to sell a share of Apple is $127.45.

Why is there a bid/ask spread and not just a single stock price?

The stock price that you see on a stock ticker on TV is the last price at which a stock was purchased or sold. The price that you can purchase or sell that stock at, however, is not necessarily the ticker stock price, but rather a price in between the stock’s current bid and ask prices.

This might be a little confusing at first, but once you understand bid/ask spreads it will feel intuitive.

If “Person A” is offering to buy a stock at a price that is the same as or higher than what “Person B” is willing to sell it for, they will make a mutually agreeable trade. Person A will buy the stock from Person B for the agreed upon price. It’s important to note that Person A & B do not actually communicate with each other. There is a “market maker” that takes customer order flow and turns bid & ask orders into trades. This is the “market” I was referring to above.

When a bid price and ask price overlap (as in the above example) a trade is executed. What that means is that all bid/ask prices that lead to agreeable transactions turn into trades.

For example, if I am bidding on one share of Apple for $127.43 and someone is selling that share at the same price or below, my bid will go away and my order will be filled. If there are no other bids at $127.43 or higher, the bid price will automatically adjust to the next highest bid for Apple stock.

In practice, the stock market is a constant back and forth between people “asking” and “bidding” on underlyings, and the market makers executing trades when their offers overlap. You can sort of think of it like a really big auction where there are a lot of sellers and a lot of buyers all competing with each other to get the best deals.

The bid and ask prices that you see on the dough platform will never overlap because all overlapping offers are filled as successful trades. The tightest bid/ask spread you’ll see will be one penny wide.

A displayed bid/ask price means that one person is asking more for their security than another person is willing to pay for it (like the first Apple example). The trades are not made because there is a difference in price between what someone is offering to sell the security for and what someone is willing to pay for it. That difference in price is the bid/ask spread.

What does this tell us about liquidity?

liquidity-teardrop-dough

The bid/ask spread helps us examine liquidity in underlyings because it tells us how easy it is to buy and sell the underlying at fair prices.

If you wanted to trade options in an underlying like $SCTY (ticker symbol for Solarcity), you can look at the option chain to see the bid/ask spread or on dough you can look for the orange teardrop icon with a line through it (displayed to the right) to see if the chosen option is liquid. If the orange teardrop icon is displayed, our formula deems the option illiquid.

If you look at the picture below in the “Edit Option” box, you will see that for the July $50.00 put in $SCTY the bid price is $0.72 and the ask price is $0.87.

So what does bid/ask spread tell us about placing trades in $SCTY?

bid-ask-prices-scty

Looking at the bid/ask spread we know that if we sold the $50.00 put for the bid price, we would be down $0.15 from the very start of the trade.

We would initially sell the put at the bid price of $0.72. To close the position, we would have to purchase the option back at the ask price of $0.87. Starting a trade with a significant loss of value is not what we want to do. Another way of referring to a big bid/ask spread, like in $SCTY, is saying the underlying is difficult to trade, or illiquid.

An example of an underlying with a smaller bid/ask spread would be more liquid underlyings like $SPY or $AAPL. If you examine their option chains you will see that their bid/ask spreads are relatively small. You are able to buy and sell the underlying at similar prices, or what we would call fair market prices.

A non-options example of a bid/ask spread is purchasing an engagement ring. If you buy an engagement ring for $1,000.00 (at the ask price), as soon as you buy it you will have lost value. If you tried to sell the ring you just bought for $1,000.00, you wouldn’t be able to get the same “ask price” that you paid for it. Instead, you would have to find the best “bid price” which would be a lot lower than the ask price.

Aiming for the mid price

Although the bid and ask price is what the market is currently offering, we do not need to enter our trades at those prices. Instead, we usually enter our trades at the mid price, or the price in between the spread.

In the above $SCTY example, the option is bid $0.72 and ask $0.87. When looking to trade an option, we wouldn’t initially enter the option to be sold at its natural price of $0.72, but instead we would enter a higher price to see if we could get a better fill.

If you look at the bottom left of the trade page (pictured below), you will see an area to adjust the price of your trades. You will also see the bid, ask, and mid price on the bottom center of your screen to give you a better idea of where you should enter your trades.

mid-price-bid-ask

Entering trades at their mid prices will improve the prices you get filled at, but if the underlyings are illiquid the large bid/ask spreads will still create significant gaps in prices.

Bid/Ask Spread Conclusion

Bid/Ask spread is one of four criteria we look at when identifying liquid and illiquid underlyings. Looking at all four criteria will give you a better understanding of your ability to trade in and out of underlyings at the most fair prices.

  1. Bid/Ask Spread
  2. Stock Volume
  3. Strike Price Volume
  4. Open Interest

Bid/Ask Spread Recap

  • The bid price is the current highest price the market is offering to buy an underlying.
  • The ask price is the current lowest price the market is offering to sell an underlying.
  • Bid/ask spread is the difference between the ask price and the bid price.
  • Large bid/ask spreads are an indicator of an illiquid underlying.
  • It is more difficult to trade in and out of illiquid underlyings with large bid/ask spreads for fair prices.


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