Stock and option “prices” are the bid and asked price quotations posted by market makers (MM) or exchange specialists, not to be confused with the prices of completed securities transactions.
The bid price quotation is the price at which the MM or specialist is willing to buy a specified number of shares or option contracts. The ask price quotation (the asked price, or “offer”) is the price at which the MM or specialist is willing to sell a specified number of shares or option contracts.
As a general rule, you buy at the asked price (the low market offer) and sell at the bid price (the high market bid). Your order may get executed (filled) at a slightly different price, depending on a number of factors covered further on. The last sale price shown may be irrelevant – the bid and asked prices are what matter; they are what orders must be based upon.
Different market makers can bid and offer for the same security at different prices. The high bid and low offer quotes are together known as the inside quote, for both stock and option prices. Stock option prices are quoted in nickel ($0.05) increments for premiums under $3.00, and in dime ($0.10) increments above $3.00. As of this writing, a few companies have option prices quoted in penny ($0.01) increments as part of a test program.
Stock prices can be quoted in penny increments, or less. Bid and asked quotes are known as the “market” prices. This is important because market makers are only obligated to buy or sell at market prices, when a so-called “market order” is entered; limit orders can be ignored.
For example, the bids and offers for RadioShack Corp. (RSH) stock might look like the table below, which shows the market makers in RSH and their respective buy/sell quotes. In market parlance, these are the MMs “on the box” – whose quotes for RSH are published on Nasdaq. A MM can cease quoting a stock or option series at any time, but if it does publish quotes, the quotes must usually be firm quotes as discussed further below.
RadioShack Stock Bid-Ask Table
|Market Maker||Bids||Market Maker||Offers|
|Bear Stearns||20.04||National Securities||20.07|
|Jessup & Co.||20.04||Jessup & Co.||20.08|
|Merrill Lynch||20.03||Bear Stearns||20.09|
|Legg Mason||20.02||National Securities||20.10|
|National Securities||20.00||Legg Mason||20.12|
In the above example, the highest bid is $20.04, and the lowest offer is $20.07, so the inside on RSH (that is, the high bid and low offer quotes) is 20.04 x 20.07. The spread between the inside bid and offer is $.03. The last transaction went off at $20.04; obviously, a sell. A market sell order should be executed at 20.04, a market buy order at 20.07, until the quotes are revised. A sell limit order for $20.09 is $0.05 above the highest bid price. The order will not be filled unless $20.09 becomes the new bid price.
The MM is free to ignore it, since it is a limit order above market price, not a market order. Market makers whose quotes are below or above the inside are staying out of the action, meaning that they are only willing to pay less than or sell for more than current inside quotations.
When a market maker (MM) posts a bid or asked price quotation for a security, the MM is in fact obligated by law to buy or sell a certain number of units. SEC Rule 11Ac1-1 requires a MM or exchange specialist to buy or sell at the posted quotations a number of securities at least equal to its published quotation size (quote width). That is, bids and offers must be firm. After filling the order, it can revise the bid or offer, or it can change the quotation size – but not below the exchange minimum. Market makers and exchange specialists, by definition, must publish buy and sell quotes (both sides) and stand ready to buy and sell the securities in which they make markets.
The quote width varies by exchange (including Nasdaq), but the standard for option exchanges is 10 contracts (known as 10-up). See for example, CBOE Rule 8.7(d)(ii). In fact, rules on quote width are somewhat complicated, with numerous exceptions, and each exchange has its own rules. And of course, all must comply with SEC rules, such as the one noted above.
Thus if a 25 Call is quoted at 1.25 x 1.40 with a 10-up quote width, a MM would be obligated to buy 10 contracts at the posted $1.25 bid price on a market sell order, or sell them at $1.40 on a market buy order. Quotes entered as a market maker (not for a customer) therefore must be “firm” quotes – good for the published quote size. See for example CBOE Rule 8.51. Once the MM buys 10 contracts at the posted quotation, it is free to raise or lower the quote. If your order is for 25 contracts, for example, then quite obviously the MM does not have to fill the entire order at the posted market quote, since it is larger than the quote width. Of course, the published quotation size can be larger than 10 contracts.
If a MM is bidding $20.04 for 2,000 shares of RadioShack Corp., it is obligated to buy 2,000 shares of RSH at the $20.04 bid price. However, if a 1,000-share sell order is filled at the 20.04 price, the MM may raise or lower the bid if there are no market orders for RSH at that time. If there are other market orders, they must be filled and the entire 2,000 share quote-width bought before the MM can revise the quotations.
Suppose the market for the call series is falling like a set of dropped car keys? The MM’s will keep lowering their quotes with the movement in the underlying stock. There may be many market orders stacked up, and they are filled in the order entered. But the MM can buy 10 contracts at the posted market quote, drop to a new bid price and buy 10 more, etc. The quote-width requirement does not apply during the morning’s “opening option rotation,” nor when a security is being stressed.
If you are worried about bid-ask spreads, make sure to choose a good options broker for example, compare thinkorswim vs tastyworks and see where you can get better commissions costs.
Strike Price Intervals
As noted earlier, option strike prices are not random but are instead normally presented at regular price intervals, depending on the stock price:
$ 2.50 – stocks up to $25
$ 5.00 – stocks priced $25 to $200
$10.00 – stocks above $200
These intervals are not sacred; stocks over $25 can and many do have strikes in $2.50 increments. New strike listings are added when a stock reaches a high or low strike price, though the options already available continue to exist. As noted elsewhere, selected stocks have options with dollar intervals (one-point strikes) as a result of a pilot program. Odd strike prices (e.g., 15.50 or 23.85) can occur as the result of reverse stock splits or other corporate events, in which event the option contract is adjusted and the option symbol is changed. Many liquid stocks now have option strike prices only $1.00 apart, except for the January options.
The tick (minimum price variation) is the smallest unit price change allowed in trading a security. For stocks, the minimum tick is a penny, or less. Until 2001, stock prices were quoted under the old fractionalization scheme – eighths and quarters. This resulted in huge spreads that really picked the pockets of traders and investors. That year the SEC forced decimalization down the financial industry’s throat – quoting prices in pennies, essentially, getting rid of the fractions. Decimalization has resulted in much narrower bid-asked spreads, among many other benefits.
For a listed option under $3 in price, the tick currently is $0.05 and for a listed option over $3 in price, it is generally $0.10. Thus if an option premium is less than $3.00, the ticks can be in nickels or dimes, but if over $3.00 the ticks will always be in dimes. This is fractionalization in twentieths and tenths and it, too, is changing. Penny pricing (0.01 tick increments) for stock options exists for certain stocks and is the norm on highly liquid options due to their popularity.
As noted above, the bid-asked spread is the inside spread between the high bid price quote and the low offer price quotation – $20.04 (bid) x $20.07 asked, in the above RadioShack example. The tick to some extent dictates the spread between the highest bid and lowest asked prices. For example, if the tick on an option is $0.10, the minimum spread will be $0.10 and probably will be greater. Spreads on options with a $0.05 tick could be as small as $0.05 but usually are larger. It is odd, but refreshing, to see option quotes such as $1.32 x $1.36 on options that have penny pricing and – generally – smaller spreads.
Beware of buying or selling any option when the spread is greater than $0.30. Since most retail traders sell at the bid and pay the ask, large spreads pick their pockets. If an option is quoted 1.00 x 1.30, for example, a buyer likely would pay $1.30, but selling it upon a change of heart a few minutes later at the same quotes, would only receive the $1.00 bid – a $0.30 loss (23%) due solely to the large spread. A liquid option in this price range should have a spread of $0.10 to $0.15 at most.
Worse, large spreads almost always indicate poor liquidity, since market makers widen the spread to protect themselves. Liquid options tend to have a much tighter spread.
Lastly, note that while options expire, penny stocks which cost about the same often as LEAPS options frequently do not expire and can be used as longer-term gambits.