Bid/Ask Spread Question

I maintain an EOD database of selected optionable equities.

The main criteria for inclusion into my database include the following:

* Option liquidity and open interest
* Bid/Ask spreads

Since quite a few of you are former MM's, here is the question... how are the bid/ask prices determined?

For example, why does one $50 equity have B/A spreads of $.05 and another $50 equity with similar volumes and Open Interest have a B/A spread of $1.40?

Roughly, my tolerance level for selecting option trades is that I avoid equity options whose B/A spread is more than a nickle per $15 increment in underlying price.

Is there some logic to these large divergences in B/A spreads that an options trader should be aware of?

Mech

 

EOD data is severely flawed.

Many market makers arrange for the bid/ask spread to widen one minute before the closing bell, making the date less useful to you.

MMs have all sorts of ways to raise and lower bids and offers, tighten and widen markets etc.

When anxious to buy the bids can be raised. Market width is determined by order flow. If pepole are going to hit the bids and take the offers, there is zero incentive to narrow quotes.

When the MMs truly want to trade actively and capture more order flow, they narrow the bid/ask spreads. There is no consistent rule that applies all the time.

Mark

 

You completely misunderstood the post.

My EOD database is of the underlying equities, NOT the Options. The data is good.

The B/A spreads I ask about are from LIVE quotes of the Options Chains.

So I repeat... Can anyone explain why the Option B/A spreads are so radically divergent for different underlyings with similar strikes, volumes and open interest.

Don't let the EOD database I mentioned cloud the discussion.

 

Lots of things. (Ambiguous question, Ambiguous answer)

Post some examples next time.

 

I doubt that your EOD is flawed; however Mark is partially right. As an ex CBOE MM i can tell you that is all about open intrest and the bets that the MM's want to make. It is just that simple. They pay for the right to make markets as wide or as narrow as the pit agrees and the CBOE allows. If they are heavy in a pinned strike or need to get out of one leg of a trade, it will most certainly change the B/A spread accordingly.

You can find out through the exchanges the max width of the B/A, I am sure it has changed since I left.

Hope this helps.

AGY/690

 

Mech, bid/ask prices are not "determined." They just are what they are - the result of a lot of competition between buyers to buy and sellers to sell (tight bid/ask spread), or very little competition between buyers and between sellers (wide bid/ask spread).

Take stock XYZ which has little volume. Let's say that 1000 people around the world are interested in the ATM 105 calls. Of those, the one person who is most anxious to buy those calls is willing to pay 3.10. The one person who is most anxious to sell those calls is willing to sell them at 3.60. De facto, the bid/ask spread on those calls is 3.10 bid at 3.60. Nobody "determined" that, it's just that as it happens, nobody in the world is willing to pay more than 3.10 and nobody is willing to sell them at less than 3.60.

Now take a stock in which there is much more interest, and much more volume, such as SPY. Let's say that the volatility and everything about SPY is exactly the same as XYZ except for one thing - instead of 1000 people worldwide, there are ten million people worldwide actively trading the ATM SPY 105 calls.

With so many more people having their own reasons to want to buy those calls, SOMEBODY is willing to pay 3.35. With so many people wanting to sell those calls, SOMEBODY is willing to sell them at 3.36.

So the tightness of the bid/ask spread is simply a phenomenon that, most of the time, is a function of the volume and interest (liquidity) of that security.

But even if two securities have approximately the same volume and open interest, it could be that at some moment in time nobody is particularly interested in buying and nobody is particularly interested in selling one security, which would cause a wide bid/ask spread. At the same time there may be frenzied emotion surrounding the other security, with a lot of bidders and a lot of offerers, resulting in a tight bid/ask spread.

 

Thanks DMO for a very thoughtful answer.

It was my (mistaken) impression that it was in the MM's financial interest to maintain reasonable B/A spreads in order to encourage buyers and sellers to 'play'.

I'll start paying attention to Bid Size and Ask Size in an effort to better understand.

And KINGOFSHORTS... ambiguity happens!

I'll probably run across some examples of B/A spread widths tomorrow and will post them if they are interesting.

But it is not a big deal. If the B/A spreads are too wide for me then I just look at other opportunities.

Just trying to understand the game better.

 

From the MM's vantage point, it's competition with other MM's that will force them to make tighter markets.

Let's imagine what it was like before the electronic era - when markets were basically made by MM's in the pit. Say I'm the only MM for XYZ stock options. I'm asked for a market in the ATM 105 calls and - since I have no competition and it's "take it or leave it" - I'll make an ultra-wide market of 3.00 bid at 4.00.

Somebody from another pit overhears, comes into my pit and says "Hell, I can do better than that wimp dmo, I'm 3.10 bid at 3.90."

Somebody else comes in and sees we two have a sweet deal and wants the action for himself, so he tells the broker he's 3.25 bid at 3.75.

That continues until finally somebody makes a market so tight that nobody else wants to make it tighter - they'd rather miss out on the trade than make a higher bid or a lower offer.

With the electronic markets now, the public is much more part of the equation. Let's say that among market makers, the best market is 3.48 bid at 3.52. That's posted on the screen for all the world to see. As it happens, Joe Blow in Dubuque Iowa is willing to pay 3.49. Another retail trader somewhere is willing to sell at 3.51. They send in their orders, and now the screen shows a market of 3.49 bid at 3.51.

Mech, I'm sure you've had the experience of seeing a market of say 3.50 bid at 3.60, and you didn't want to pay 3.60 but you were willing to pay more than 3.50, so you sent in an order to pay, say, 3.54 for 50 options. Then a moment later you saw the bid on the screen say "3.54 for 50" and you thought "Hey, that's me!"

Well, every bid and every offer you see is just some MechTrade somewhere who for his own reasons at that moment is willing to buy or sell at that price. He may be a MM or he may be a retail trader.

 

I just wanted to say that I'm very impressed with the quality of the answers on this thread. For once, ET managed to not turn a simple question into an all-out war.

To the people who answered the questions: (and I know I'm a third party here) thank for taking the time to answer this man's questions.

The posts describing how spreads work were well-thought out and simple as well.

Nice job guys.

 

Thanks for another great reply.

You made it easy to see how other MM's jump in and make better B/A's (both sides simultaneously) which creates competition.

But as a retail trader who only wants to make either a Bid or an Offer (not both), and the quote is your ultra-wide 3.00 Bid at 4.00, is it really worth my time to Bid 3.05 or Offer 3.95?

Since I'm only competing on one side of the trade, wouldn't it be better for me to just move onto a different underlying where the B/A spread is already tight?

And if that is the case, isn't it to the MM's detriment to attempt to maintain the ultra-wide spread that only a retail trader in full dementia might step into?

Thanks again.