Bid vs. Ask: Why It Matters in Options Trading

by Simon Hopes Author

For the adventurous investor, options trading is a high-risk, high-reward investment strategy that can offer enormous payouts. However, it's substantially more complicated than traditional trading and comes with its own vocabulary and procedures. Among these unfamiliar terms are ask, bid, and bid-ask spread. Learn what these terms mean, how to calculate bid-ask spread, and why it's important to do so.

What Are Asks and Bids?

In options trading, investors purchase a contract that entitles them to buy or sell some or all of the underlying asset. Investors sell contracts by establishing an "ask," which is the least amount of money they're willing to sell the stock for. A "bid," meanwhile, is the most amount of money an investor is willing to pay for an options contract. It's rare for the bid and the ask price on an options contract to be the same. Usually, the ask is higher than the bid.

What Is a Bid-Ask Spread?

The bid-ask spread is the difference in price between the bid and the ask. For example, if the ask price on a stock is $20 and the bid price is $19, then the bid-ask spread is $1. Investors incur this cost as part of their transaction, so it's important that you know what the bid-ask spread is before making an investment.

The bid-ask spread's value varies based on factors like the type of order and the liquidity of the contract's security.

Types of Orders

Investors can place five types of orders for options contracts. The bid-ask spread can impact the overall value of the sale for each of these orders.

Market Order: Orders are filled at the market or prevailing price.
Limit Order: An investor places an order to buy or sell a specific stock at a set price or higher. If the cost drops below their set price, they will not sell the stock.
Day Order: The order lasts only for the length of the day, and if it's not fulfilled, it's canceled at the close of business.
Fill or Kill: The entire order must be filled immediately or the order is canceled.
Stop Order: The order goes into effect when the stock reaches a certain price. It's guaranteed to sell at the set price or lower.

Liquidity

The underlying asset's liquidity impacts the amount of the bid-ask spread. Highly traded companies have a small bid-ask spread due to their popularity, while less well-known or infrequently traded companies often have a much wider bid-ask spread.

Calculating the Bid-Ask Spread

You can calculate bid-ask spread as a dollar amount or as a percentage. Both are useful metrics for determining your gains or losses on a trade. To determine the bid-ask spread, subtract the bid amount from the ask amount. This will give you the dollar amount of the bid-ask spread. To find the percentage, use the following formula:

bid-ask spread (%) = (ask - bid) / ask * 100%

Understanding bid, ask, and bid-ask spread is vital to successful options trading. Ensure you accurately calculate the bid-ask spread before placing any type of order to know what you stand to gain or lose.