Beware of Slippage! Watch Your Bid-Ask Spreads

How to reduce the negative impact of bid-ask spreads on your trades

Jul 31, 2015 at 4:24 PM
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When you're trading options, the "bid-ask spread" refers to the difference between the bid price and the ask price on a given strike. (Remember -- the bid is the highest price a buyer is willing to pay for an option, while the ask is the lowest price a seller is willing to accept.) Generally speaking, the bid-ask spreads on heavily traded, liquid options will be narrow, while the spread on lightly traded options is likely to be wider. This brings us to the concept of "slippage."

Let's say that you're interested in buying to open a call option that's currently bid at 0.40 and asked at 0.45. If you were to buy the option at 0.45, your total initial premium would be $45. Were you to turn around and immediately sell to close the option at the prevailing bid price of 0.40, you'd net just $40 -- resulting in a loss of $5 on the trade, or 11% of your upfront premium. In other words, you're already sitting on an 11% loss as soon as you enter the trade -- this is slippage.

However, let's say that you were looking at a more popular call option that was bid at 0.43 and asked at 0.45. In this scenario, your slippage would be significantly lower, amounting to less than 5% of your initial premium.

To reduce the negative impact of slippage on your option trades, it pays to focus on contracts that are sufficiently liquid and feature narrow bid-ask spreads. Of course, if you've got a killer trade idea and you believe you can easily make up the increased slippage on a less-than-popular option, there's no rule that says you can't go ahead with the trade. As with all investing decisions, it's largely a factor of your personal risk tolerance and trading objectives. Nevertheless, given the number of variables that can impact your option trades, you should definitely take stock of bid-ask spreads before you enter a new position.


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