Tales of a Technician: How to Split the Bid-Ask Spread like a Pro | Tackle Trading
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.
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)
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.
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.
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.
Tackle Trading LLC (“Tackle Trading”) is providing this website and any related materials, including newsletters, blog posts, videos, social media postings and any other communications (collectively, the “Materials”) on an “as-is” basis. This means that although Tackle Trading strives to make the information accurate, thorough and current, neither Tackle Trading nor the author(s) of the Materials or the moderators guarantee or warrant the Materials or accept liability for any damage, loss or expense arising from the use of the Materials, whether based in tort, contract, or otherwise. Tackle Trading is providing the Materials for educational purposes only. We are not providing legal, accounting, or financial advisory services, and this is not a solicitation or recommendation to buy or sell any stocks, options, or other financial instruments or investments. Examples that address specific assets, stocks, options or other financial instrument transactions are for illustrative purposes only and are not intended to represent specific trades or transactions that we have conducted. In fact, for the purpose of illustration, we may use examples that are different from or contrary to transactions we have conducted or positions we hold. Furthermore, this website and any information or training herein are not intended as a solicitation for any future relationship, business or otherwise, between the users and the moderators. No express or implied warranties are being made with respect to these services and products. By using the Materials, each user agrees to indemnify and hold Tackle Trading harmless from all losses, expenses and costs, including reasonable attorneys’ fees, arising out of or resulting from user’s use of the Materials. In no event shall Tackle Trading or the author(s) or moderators be liable for any direct, special, consequential or incidental damages arising out of or related to the Materials. If this limitation on damages is not enforceable in some states, the total amount of Tackle Trading’s liability to the user or others shall not exceed the amount paid by the user for such Materials.
All investing and trading in the securities market involves a high degree of risk. Any decisions to place trades in the financial markets, including trading in stocks, options or other financial instruments, is a personal decision that should only be made after conducting thorough independent research, including a personal risk and financial assessment, and prior consultation with the user’s investment, legal, tax and accounting advisers, to determine whether such trading or investment is appropriate for that user.
Originally published at https://tackletrading.com on June 22, 2020.