Compared To Stocks, Options Investors Pay A High Trading Price

A typical bid-ask spread for an option on a stock or an ETF would be much larger than for the stock or ETF itself.

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It is common for investors to turn to an options market when it appears that the financial markets will be volatile, either as a way to protect themselves against downside losses or to make a prediction about the future direction of the markets.

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We decided to take a look at how much it costs to trade options, which are essentially contracts that give a holder the right to buy or sell a financial asset at a set price within a specified period, and we decided to see how costly it is to trade options.

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Based on the spread between the bid and ask prices of the option, we calculated how costly it would be to trade each option based on the price at which it could be sold and the higher price at which a buyer might be willing to pay at the close of each business day (measured at noon Monday through Friday). It is the market maker who executes the transaction and receives the difference between the two.

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There is a spread between the ask and the bid price, usually expressed as a percentage. An increase in the spread between the bid and ask prices means an increase in this percentage number, which means a higher transaction cost. For example, if you buy and sell an option with a spread of 2%, you must earn at least 2% to break even.

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The price is high

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Among the things that we found was that the options we studied on stocks and ETFs, which we examined in depth, had much larger bid-ask spreads and were typically more volatile than options on those stocks and ETFs themselves.

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It has been very interesting to study the one-month and one-year options for a small sample of the top ten most heavily traded stocks and ETFs from the beginning of this year through March 15 in collaboration with my research assistants (Clarita Orosco and Hsiung Huei Lee). At midday of each trading day, we checked the spreads for each contract so that all spreads were actively quoted, and we also took other precautions to ensure that the spreads were not outliers.

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It is estimated that during this timeframe the median bid-ask spread for a one-month call option "at the money" - an option to purchase a stock or ETF that is currently trading at the pre-determined price on the date of the option - was 1.78%. We were tracking stocks and ETFs as well as their options over the same period and observed bid-ask spreads that ranged between 0.02% and 0.10% for the stocks and ETFs we were tracking.

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A stock or ETF with an option bid-ask spread of nearly 100 times the underlying stock or ETF could be expensive for investors.

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Factors affecting spread

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In general, out-of-the-money options were more expensive than in-the-money options. An option is in the money when the market price of the underlying security is above the set price, in the case of a call option, or below the set price, in the case of a put option, which is an option to sell a security.

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Finally, the longer the time left before an option expires, the wider the spread tends to be. So long-term bets on the direction of a stock or ETF are more expensive than shorter-term bets.

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It should be noted that the bid-ask spreads we found were for the most heavily traded stocks and ETFs. When you venture into more thinly traded securities, it isn’t uncommon to see bid-ask spreads over 10%. 

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All in all, the options market is a costly place to trade, compared with the stock market. Investors should consider those costs whether they’re using options as protection against steep market declines or they’re speculating on where the market is headed.

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