We spent a lot of time discussing stock market quotes, spreads and transaction costs.
Today, we’ll look at options trading. It’s no secret that the options market is very different from stocks – and their spreads are no different.
Option prices are driven by option Greeks
Black-Scholes was revolutionary in helping to price options. It quantifies how factors such as time to expiration, currency (the distance of the strike price from the underlying price), and volatility combine to determine the fair price of an option.
In the options market, we understand how it works by looking at actual prices. As shown in Figure 1, the higher the in-the-money option (delta), the higher the price. Additionally, options with longer expiration times have higher prices.
Figure 1: Option prices largely depend on the option’s currency and expiration time
This should make sense – options with more delta (money) are more likely to be exercised. Additionally, the longer the time until expiration, the more likely the price will change, making the option “in-the-money.”
However, this “non-linear” nature of option prices makes it more difficult to compare the cost of the spread for the same option underlying.
The spread as a percentage of the option price
In the chart below, we show how the bid-ask spread has evolved for QQQ ETF options, with the ETF currently trading around $500.
When considering stock trading costs, the stock spread is often compared to a percentage of the stock price. For the QQQ ETF, an average spread of 2 cents equates to less than half (0.5) basis points (or 0.005%).
However, because options on the same $500 stock have very different strike prices, their prices are also very different. For example:
- The $475 call is already a $25 in-the-money option, and its extrinsic value should make the option worth even more than $25.
- However, the $525 call option with one day to expiration will likely become worthless by expiration, and therefore may be worth only a few cents.
Even if both options are highly liquid and the spread is 1 cent, that 1 cent is a “cost” for an option worth a few cents compared to an option worth over $25 will be higher.
In Figure 2, this is exactly what we see:
- Out-of-the-money options have a lower option price, so their spread accounts for a higher proportion of the option price.
- Options with shorter expiration times (orange dots) lose extrinsic value, so their spread cost (expressed as a percentage) increases faster.
- Interestingly, options with larger theta (blue dots) decline in price more slowly, as they may still eventually expire in-the-money. This causes their option spread cost percentage to grow more slowly.
Figure 2: Option relative spreads are higher for cheaper strikes and lower for more expensive strikes
Spreads are measured in cents
However, when looking at spreads in U.S. dollars, we see almost the opposite pattern. The relatively broad strike (in percentage terms) is actually smaller (in dollar terms).
Figure 3: Option spreads in USD follow the same trend as their prices
Remember, each option represents 100 shares of the underlying stock, and a $1 spread is equivalent to 1 cent per share, which is similar to the spread on ETFs.
The chart shows:
- Once an option has intrinsic value (in-the-money value) and delta increases, it trades at a spread more like the underlying stock. This makes sense because market makers need to hedge with the underlying stocks and more likely need to offset adverse selection if price moves against them.
- However, the incidence of adverse selection is much lower for options that have no intrinsic value and are unlikely to earn any profit at expiration. As a result, spreads actually tightened (in cents). In the most extreme cases, short-term out-of-the-money strikes can quickly become very cheap (in cents).
- In comparison, options with longer expiration times are more likely to expire in-the-money, even if they are now out-of-the-money, so their spread costs are higher.
what does that mean?
It is interesting to see how the leverage of options, caused by different strike prices (monetary) and expiration times, changes the spread (expressed in percentages and cents).
As we’ve discussed in the past, spread costs are important in understanding the cost of trading stocks. However, for stocks, the cost of trading each stock is fairly stable over time. What we see here is that due to the multidimensional pricing of options (as shown in Figure 1, where price movement limits are combined with currency and expiration time), it is difficult to compare the spread cost of one option trade with another. Compare the spread cost of an option trade. This makes transaction cost analysis of options more difficult (some might say impossible).
