Last update: July 2021
Welcome back to the Options 101 series presented by Tackle Trading! In this series, I will examine some of the basic concepts that you need to understand as you start to trade options. Options contracts are derivative products where their value is dependent on factors driven by the stock price, time til expiration, implied volatility and characteristics that are driven by the strike price you trade. In this week’s article, we will look at the Bid/Ask spread, open interest, volume, and how these characteristics affect a trader’s decision-making.
Every option has a price. This price can be thought of in several different ways. The mark price of the option is the one you see in your position statement most often. But, this may not be the actual ‘price’. Options are a product that is traded by both buyers and sellers. Buyers offer the price they’re willing to pay – this is the bid price. Buyers are bidding exact prices to try to get filled. Sellers offer prices they’re willing to receive to sell the option. Sellers are bidding exact prices to try to get filled. These prices establish the bid/ask spread. Let’s use an example to help everyone understand how these numbers are established.
If you look at an option chain you will see the Last, Mark, Bid, and Ask. The bid price shown is the best available bid price that is quoted from one of the major exchanges. If the bid price on a specific option is 2.40. That means that there may be many bids….say 2.10, 2.20, 2.25, 2.35, and 2.40. The highest number is the one shown on the screen because it represents the best bid being traded on the market. On the same option, sellers are probably offering many prices as well. They may be coming in at 2.80, 2.70, 2.60, 2.55, and 2.50. These are all ‘asks’ and offers being given by sellers.
The bid-ask spread on the example above would be shown as 2.40 / 2.50. These are the tightest version of the spread. The distance between bid and ask reflects the liquidity of the underlying option. If you’re trading options short-term using day, swing, or position trading strategies you want to look for options that have relatively tight bid-ask spreads. The general rule is to look for spreads that are .30 or less in distance between bid and ask. This establishes a ‘liquid’ spread.
Larger-priced stocks, indexes and ETF’s may have slightly larger spreads. You CAN still trade these. If you trade options that have larger spreads, you run the risk of poor fill prices or volatile conditions opening the spread even further. The more volatile the options, the more likely the spread will open up to a large distance during certain economic events, at the market open or high periods of market volatility. You can still trade these options, but if you do, you need to learn how to execute limit orders and get good fill prices.
Some options trade on spreads that are only 5 or 10 cents in increments. Other options trade on penny increments. Your offer to the market in your order should reflect the type of option chain you are trading. If you look at a bid/ask spread and the prices are 1.47/1.51 then those are penny options. It’s easily identified by looking at the chain and simply finding the numbers. Do the increments move in only .05 or .10 increments or do they move in pennies? Penny options can be ordered for penny fills. If you offer .67 for a spread, then it should be because its a chain that has penny options. If you’re a trader who uses Thinkorswim, the automated mark price built into vertical, calendar and multi-legged spreads will come in at the mid-point ‘Mark’ price. Sometimes, even with nickel or dime options, it may come in at a penny increment. You need to adjust your offer to a nickel increment to put yourself in a position to more likely get a fill price.
Open Interest is a measurement of the number of open contracts on the market. It adds up all the open buys and sells and tally’s the number and puts it in your option chain. A general rule is to trade options that have 100 contracts of open interest or more. There are some exceptions. If a contract was just created on a highly liquid stock, then it’s possible the open interest will be low, but the option will still be tradeable. If you’re not sure, then go with the rule that there should be at least 100 contracts or more before you trade that strike price. For new traders, it’s better to lean on the side of safety and make sure you’re trading liquid options. Open Interest is a reflection of liquidity.
Volume represents the number of options contracts traded that day. In the morning, volume will naturally be low. For the most traded options in the market, volume will come in early in a trading day. Consider what stock you’re trading, what time of day it is, and look at all of the strikes in the option chain before making a judgment on whether the volume is high enough for your trade. It’s nice to see some volume – but its the lowest priority of the 3 concepts we’ve examined today. The bid/ask spread reflects a willing market. The open interest is a reflection of a traded market. The volume is simply a measure for today’s trading. If you have a tight bid/ask spread, over 100 contracts of open interest, but little volume you can still safely make your trade.
In our next section of the Options 101 series, we will examine the Language of options including calls, puts, in-the-money, Out-of-the-money, and at-the-money. If you have questions from any of these posts, please post in the Clubhouse, email us team@tackletrading, or tweet me @timjusticeutah.
Thanks for your time reading, and get in the Game!
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