Why are they so huge? Is there really so little liquidity to warrant such godawful spreads? Can retail customers cut into the inside bid/ask with their own limit orders (ECN style)?
There are a number of reasons why option spreads are so high. Like you mentioned, liquidity is VERY low compared to stocks. The majority of option contracts do not trade in any given day, so the market maker has to have a wide spread to protect themselves. Even the most popular options, such as at-the-money options on the QQQs, trade about 10,000-30,000 contracts a day, which is miniscule compared to stocks. Retail investors cannot post their own bid/asks so this contributes to the high spread. In addition, remember that options are a zero-sum game. Meaning for every dollar you make, someone else has to lose the same amount. You can be sure that the market makers will price options in their favor. I doubt options will ever reach the tight spreads of stocks if only because there are so many of them. Each stock can have dozens of option contracts(puts, calls) at various prices for a given month. Extrapolate that over different monthly contracts, and you'll see why liquidity is so low.
I believe there is a relatively new rule that prevents retail traders from taking frequent trades in options. Basically it prevents us from acting like a market maker, something that happened to stocks in the early to mid-90's. This protectionism contributes to artificially wide spreads.
It's terrible that retail traders are not able to post their bids/offers. So is there anyway for a retail trader to buy at the bid and sell at the ask? If you put out a bid, is there any chance it will be hit even thought it's not "posted"? Hrm, I think it's time for options ECN.
Traderkay, It would be nice to have an options ECN, but I'm sure there is a mountain of regulatory issues in the way. Plus, with the low liquidity only a handful of option contracts could actually benefit from such an ECN. As for trying to buy on the bid and selling on the ask, you can send such an order, but the market maker is under no obligation to fill you, until your limit price reaches the offer(to buy) or bid(to sell). When you route an options order, no one else but that market maker can see it. In fact, almost all online brokerage firms, like datek, receive signifigant order flow payment from option exchanges. As it stands now, IB probably offers the best deal in terms of execution and commissions for the retail options investor.
You are certainly welcome to attempt and split the spread with any options contract. IB offeres you the ability to route your order to the market which looks the best, and sometimes by carefully choosing where you send your order you can obtain significant price improvement. There is no obligation however for any options MM to fill you between the spread, and they will even back away from bids and asks once you try to hit them at the inside market (although market orders for 10 contracts or less are supposed to be automatically executed at the inside price). Forget having ECN's for options. Trying to make a market in options would be death for most retail traders. Remember that options allow great leverage, and leverage always comes at a price.
It is certainly possible with Preferred or IB to post bids or asks on options and they are displayed on the quote systems. Typically the MM's will just move away from you, ie if you improve the bid, they will join you and move the ask, or they will just ignore you. You can get filled if someone using a similar system hits you, or if your bid crosses the ask. Otherwise, forget it. If enough traders used these platforms and improved spreads using the ISE, MM's would have to respond just as nasdaq MM's did. Of course, their response is likely to be to try to make it illegal.
trading options on futures maybe a whole different animal...... anyone trade options on futures here ???