Bid / Ask Spread and Commodity Trading: Don’t get Mad, get Smart
One of the biggest mistakes that beginning commodity traders make is to ignore the bid-ask spread. The bid is the price at which you can sell an option or futures contract, while the ask is the price at which you could buy an option or futures contract for. At any given time, there will be two different prices, one is the price if you are a seller and the other is the price if you are a buyer. In essence, traders will always pay the higher quote to buy and receive the lower quote when selling. If a trader was to simultaneously buy and sell an option, they would sustain a loss in the amount of the bid-ask spread. The difference between the two prices is known as the bid-ask spread.
This spread is the amount of money that the executing broker, or market maker, requires as compensation for accepting the risk of taking the other side of the trade, and providing liquidity to the market. As a market maker, once a trade is executed they must turn around and find someone to take the opposite transaction in order to offset the position. As you can imagine, the broker is exposed to risk during the time that the position is open. The more risk deemed in participating in the trade, the higher the bid-ask spread will be.
The size of the spread is largely dependent on the liquidity of the commodity option or futures market. The higher the liquidity of an option market, or a particular month and strike price, the lower the spread will be. This makes sense, a market maker is accepting less risk when taking the opposite side of a liquid contract because they can immediately offset if they wish.
In some markets the bid-ask spread is inconsequential, however, in others it can be massive and should not be overlooked. For example, copper option traders have little room for error due to the “invisible” transaction cost of the bid-ask spread. It is not uncommon for the spread to be a full cent of premium or more. Each cent in copper is $250, so a trader may be facing a scenario in which immediately after getting in to the trade the market would have to move in favor of the position by approximately 2 cents in premium, or $500, just to break even. These kinds of obstacles can leave the odds grossly against a retail trader.
While the copper futures contract is an exaggerated example, this gives you an idea of how such knowledge could avoid unnecessarily learning this the hard way by placing a market order and being reported a “shocking” fill. A good way to keep the floor brokers “honest” is to split the bid.
Before placing an option order, ask your broker to contact the trading floor for an accurate bid-ask quote. If they can’t get it for you, consider getting a new broker. Of course, market orders would be filled at the bid if it was a sell order and the ask price if it was a buy order. However, experienced option traders often place a limit order between the bid and the ask price with the intention of luring a floor broker to execute the trade. As the market fluctuates up and down, there is a strong chance that the trade will be executed at your named price. Nonetheless, anytime that a limit order is placed there is risk of “missing the trade” or not getting filled on the order. However, over time I believe that the money saved in hidden transaction costs, namely the bid-ask spread, will outweigh any supposed profits lost on missed trade.
Of course, splitting the bid with limit orders is only a guideline. There are times in which timely execution is necessary, such as a fast moving market, and a market order would be more appropriate. Should you find yourself in such a situation, it is important to have an experienced broker with contacts on the trading floor; doing so may improve the efficiency of your fill.
Many beginning commodity option traders get frustrated because they see that an option last traded at a specific price, or settled at a specific price, but they cannot get an order filled at that particular price. Some of the difference may simply be due to the fact that they are viewing an “old” quote and the underlying futures contract has since moved, but part of the price discrepancy can be attributed to the bid-ask spread. After all, we don’t know whether the quoted price was a buy or a sell.
This spread makes it possible for retail options on futures traders to speculate; don’t get frustrated simply learn how to mitigate its impact on your commodity trading results. By splitting the bid, traders play a small part in determining their fate as opposed to being at the mercy of the market.
For example, if you are interested in buying a call option on the Dow Jones futures contract and the broker tells you that it is “450 bid at 550” it would cost you $550 to buy it. If you wanted to sell it, you would receive $450 in premium. In this example, you may want to place a limit order to buy the option at $500 which is half of the difference in the spread. By the way, you will rarely hear a broker identify the ask price. They will simply say the bid, and then denote the ask price by saying “at”. So in the case of grain options, if the bid is 6 cents and the ask price is 7 cents, it would be stated by saying “6 bid at 7”. Some brokers can be very busy, and the faster they can get their point across the better.