Tales of a Technician: How to Split the Bid-Ask Spread like a Pro
June 22, 2020
Last Update: August 2021
We all come into the trading world harnessing one false belief or another. Most are born of ignorance. Some were foisted upon you by a misguided teacher. One that I held was that there was a single price for an asset. Oil is trading for $40 a barrel. Apple is worth $350 per share. Such statements are true in general. But not precisely true. Assets have two prices. One that you can buy at called the Ask or Offer. And, one that you can sell at called the Bid.
They’re virtually never at the same price. At least a penny, and sometimes quarters and dollars, separate them. The gap between the bid and ask is known as the spread, or, in fancy parlance, the bid-ask differential.
The size of the gap reflects just how liquid the asset is.
Narrow Spread = Liquid
Wide Spread = Illiquid
A Tale of Two Spreads
Here’s a stock example using AAPL.
Bid: $357.07 Ask: $357.09
A Narrow Spread
Apple shares are extremely liquid and thus boast a tiny, two-penny spread. You can buy the shares at $357.09 or sell them at $357.07. In contrast, let’s look at an illiquid stock, Chipotle Mexican Grill (CMG)
Bid: $1,058.17 Ask: $1,059.79
A Wide Spread
Chipotle shares are way less liquid than Apple, with a $1.62 spread. You can buy the shares at $1,059.79 or sell them at $1058.17. Trading assets with wide spreads isn’t fun. It means you’re sitting on a losing position right off the bat. It also means you need a bigger move in the right direction before you can breakeven. This is why smart traders only focus on liquid underlyings that have the narrowest spreads on the Street.
Split the Spread
Buying at the ask and selling at the bid is a given, but you can seek price improvement if you want. The middle of the spread is appropriately called the Midpoint, or Mid for short. Savvy traders will try to buy and sell near the midpoint to shave the spread. But here’s a key point:
There’s no guarantee you will get filled at the midpoint.
You can input a limit order and try to get filled. BUT, if your order doesn’t fill after a bit, then you will need to modify the price. If you’re buying something, then lift the price above the midpoint to increase the likelihood of a fill. If you’re selling something, then lower the price below the mid for a greater chance at filling.
So far, I’ve used stock examples to illustrate the principle. But it’s the same when trading options contracts, only the bid-ask spread is usually even wider.
Trading Options
In most brokerage platforms (including ThinkorSwim), when you input an order to buy a single call or put, it will default to buying at the ask price. The same goes for when you’re selling a single call or put, only it defaults to selling at the bid price.
I would get in the habit of shifting the price to the midpoint. Then, walk it up or down if it doesn’t fill.
Options spreads (bull calls, bull puts, condors, etc.) are a little different. The broker defaults to putting the price at the midpoint for you. This is a good thing. But, remember, there’s no guarantee you will get filled. Particularly if the bid-ask spread is really wide like on an iron condor. Remember, condors are four-legged spreads. If you’re trading four options, each boasting a bid-ask spread of 50 cents, then the spread for the entire condor is $2. That leaves a lot of uncertainty as to what a fair fill price is.
Cash Flow Condors Example
When I sell index condor on RUT following the Cash Flow Condor guidelines, I almost always have to drop the price once or twice before I get filled. I can’t even remember the last time I got filled at the midpoint the first time I tried.
Let me end with an example to illustrate.
The RUT Aug $1020/$1010 bull put is priced like this:
Bid: 10 cents Ask: $1.10
Midpoint: 60 cents
The RUT Aug $1700/$1710 bear call is priced like this:
Bid: 10 cents Ask: $1.10
Midpoint: 60 cents
If we combine both verticals to create an iron condor (Aug $1010/$1020/$1700/$1710), then the pricing looks like this.
Bid: 20 cents Ask: $2.20
Midpoint: $1.20
When I build the order, it will default to a sell limit $1.20. If I get filled immediately, then great! But I usually don’t. The bid-ask spread is a whopping $2. And it shifts around throughout the day. As a result, the midpoint is a moving target. It won’t stay at $1.20. So if I don’t get filled, I need to massage it. In this case, since I’m selling, I would cancel/replace the order and shift the price to sell limit $1.15. Then I’d let it sit for a bit. If it didn’t fill, I would lower it further to $1.10. I usually only have to do this once or twice before it fills.
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Thanks Tyler!
Is there a way to validate after-the-fact the bid-ask differential after the fill?
Great stuff! Thank you kind sir!
Cheers
jimbo
Not that I’m aware of, Jimbo. However, you should have a pretty good idea of what it was because you would have seen it when placing and monitoring the order. It doesn’t change that much, so if the bid-ask spread was 50 cents when you first input the order, then it’s a good bet that’s what it was when you got filled.