If you went to three different grocery stores, you’d probably see three different prices for a simple gallon of milk. No doubt you’d give your business to the store that charges the least for this product. And thanks to the fact that there are multiple stock and options exchanges, the same kind of “shopping around” happens every day on the open markets.
If you look at any major financial information site for any stock, you’ll find the price at which the security most recently traded. You’ll also find the “bid” and “ask” prices at which buyers and sellers have declared the price they wish to pay (or collect for) a position.
Options investors must be especially mindful of what each price means when reviewing options premiums. There’s a reason why each price is listed, and knowing what they represent can help you to make better trades.
The current price shown is the price of the most recent trade that was completed for the stock or option. This is the market value of the security. This may seem straightforward enough, but it’s important to remember that it’s not necessarily the price you would pay or receive for an option if you placed an order at that exact moment.
The price of the most recent trade can be deceiving, for two reasons. One, depending on the Web site where you are visiting to find options trading quotes, the figure can be delayed by 15 to 20 minutes and, therefore, doesn’t accurately reflect what might be happening at that very moment. Secondly, the price itself can be sort of a misnomer, as the most recent trade that took place could have been 15 minutes or even 15 DAYS earlier!
If a stock or option isn’t liquid — that is, if there aren’t a lot of shares or contracts available for trading and/or not too many people are interested in trading them — then a security’s price can remain un! changed for several months due to inactivity.
To determine the price you would pay or receive if you submitted your order immediately, you need to look at the “bid” and “ask” prices, which are never the same but do share a common purpose in giving you an accurate trading range for the option you may be interested in buying (or selling). The difference between the prices is called the “spread” and the smaller that spread, the more-liquid the option is.
The asking price, sometimes called the “offer price,” is the lowest price at which a market-maker (or, someone who owns the option) is prepared to sell the option at any given time. As an options buyer, you are looking for the best “ask,” or the lowest price for which you can buy an option.
The asking price is always higher than the bid price, which reflects orders at the level where bidders want to purchase the option. It doesn’t mean that the order will get filled — the bidder may have to eventually pay the asking price if no sellers are willing to honor the bid price.
Remember that the bid, the smaller number, is the price at which a market-maker is willing to buy a security from you. And for your selling purposes, you may want to take the highest bid price for which you can sell the option, or else you can try to “ask” for your desired price and see whether anyone bites.
The bid/ask spread is as simple as applying the law of supply and demand. The market-makers want to take more money from you by selling to you at a higher “ask” price, while giving you less money for options you want to unload by buying at a lower “bid” price.
In fact, market-makers make money on the difference between the bid price and the ask price. That difference is called the “spread.”
The bid/ask spread, then, represents the highest price a buyer wants to pay for an option and the lowest price a seller is willing to a! ccept fo r it. The delicate balance of an option’s premium always depends on a simple formula: how little the seller will accept and how much the buyer is willing to pay.
Market-makers are the ones who set the width of the spread, so it can be anywhere from a few cents to a few percentage points, depending on the asset’s value. These dealers work independently of brokerages and match up buyers and sellers by handling the buy and sell orders. This involves taking on a great deal of risk but serves to ensure that the individual or entity’s orders are not only filled, but also protected.
It’s always important to keep in mind that there are fundamental differences between stocks and options. Only the stocks that are listed on the Nasdaq (NASD) have bid and ask prices available; stocks on the S&P 500 (SPX) or Dow (DJI) do not. However, all options — regardless of which index the underlying stock resides on — are shown with bid and ask prices.
Still, sometimes options traders will find that the bid and ask fields show zeros for all of the available strike prices of a particular underlying stock or index. Why is that? Again, we can turn to the market-makers to solve the mystery.
The market-makers will often remove the previous day’s prices to wipe the slate clean before the opening bell, especially if the pricing hits psychological price points — but not always.
Occasionally, options chains will show yesterday’s bid and ask prices before the open. So, a market order entered based on these prices could be filled at a much-different price if the stock or index opens higher or lower. So, you must stay aware of price changes so that you don’t get into an option trade for far more than you planned to pay — likewise, you don’t want to accept significantly less than you think the option is worth, if you’re a seller.
No doubt that if you’ve followed a favorite stock and its correspondin! g option s, you know that investors tend to follow like lemmings — if the price goes up with volume (or increased buying), then they buy. If the price drops, they head for the exits in droves. Basing your buy or sell decisions on what everyone else is doing can be a very costly way to decide when to take your profits.
Sometimes, though, this overreaction can create opportunities for investors who are willing to run against the pack — such as, buying a stock when it has been temporarily depressed or selling when a stock’s price has been elevated for no apparent reason.
For this reason, some traders attempt to watch bid and ask prices to time their selling, but because prices move constantly (especially for actively traded positions) and also given the quote delays, you can’t know what price you will get if you are a buyer or a seller unless you use specific limit orders (that is, you set the highest level you want to pay to buy or the lowest amount of money you’re willing to accept to sell).
This underscores the importance of following a trusted expert in the field, instead of the crowd, who has insight and data that generate proper buy and sell signals, along with market/limit order perimeters.
Each option chart may show several different prices, but the most important one is the price that offers you the best return for your money.
If you enjoyed this article, check out Ken Trester’s “Take Options Losses in Stride” and “Trade Options with ‘Fun’ Money.”
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