Who is on the Other Side of Your Option Trade?

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Russ Allen

08 Aug, 2014

in Options

When you click the “Buy to Open” button on your option trading platform, from whom are you buying? And does it matter? Well yes, it does matter. It can affect the price you pay for the option, to the degree that it might make the difference between a winning trade and a losing one.

The options market is made up of multiple exchanges. Each exchange hosts many options “market makers.” The market makers are broker/dealers, whose job is to buy options wholesale and sell them at retail. These dealers are always present in the market.

The market makers’ computer systems make sure that they have a bid price and an offered price in the market at all times for all the options they deal in. This is true whether any trades have taken place in each option or not.

Their presence explains why the option chain for each stock is fully populated. All the market makers are constantly transmitting their bid and ask prices to their exchanges.

The exchanges co-operate in a committee called the Option Price Reporting Authority (OPRA), which aggregates all the data and feeds it out to the public through data vendors.  What we see on our option chains is the result of this aggregation and dissemination from OPRA.

This includes bids and offers from all of the option market makers, as well as from all other traders, including you. We see just one number as the “Bid” for the option and another for the “Ask.” But these are just the best (highest) bid and the best (lowest) ask price available among the many bids and asks from all the players.

All well and good as long as there are plenty of people competing for our business on whatever options we’re interested in. As long as that is true, the spread between the bid price and the ask price will be narrow.  The competition from other traders will keep the market makers honest; if the market makers were to try to maintain a wide bid-ask spread, they would be undercut by the other players and that spread would narrow.

That is what happens with options that are widely traded. Below is an illustration:

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Figure 1 – QQQ August Option Chain

Above is the option chain for the exchange-traded fund QQQ. This is one of the most actively traded assets in existence, and its options likewise have a great deal of activity.

At this time, QQQ was trading around $95. The $95 strike price is at the top of the above option chain. For the $95 calls, the Bid is $1.26, and the Ask is $1.27. We could sell these options at the $1.26 Bid; or we could buy them at the $1.27 Ask. The bid-ask spread is as small as it can possibly be, at just one cent. Even at some distance away from the at-the-money strikes, all of the options have bid-ask spreads of just a few pennies.

Notice the columns labeled “Volume” and “Open Interest.” The quantities there are in the thousands or tens of thousands. Volume is the number of option contracts that have traded today. Open Interest is the total number of contracts in existence for the given strike price. The fact that these numbers are very large indicates a great deal of activity, presumably by many different traders. This explains the narrow spreads.

So for the QQQ, the answer to the question, “Who is on the other side of your trade?” could very well be – “another trader.”

Now contrast this with a different ETF at around the same price:

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