We’ve previously discussed the intricacies of ticks, spreads, and trading costs in the stock market. Today, let’s explore options trading, which is quite different from trading stocks, especially in terms of spreads.
Options Prices Influenced by Option Greeks
The Black-Scholes model was groundbreaking in options pricing. It helped quantify how factors like time until expiry, moneyness (the distance between the strike price and the underlying price), and volatility come together to determine an option’s fair price.
In the options market, we can observe these factors in action through real-world prices. As shown in Chart 1, options that are more “in the money” (higher delta) are priced higher. Additionally, options with more time left before expiry also tend to have higher prices.
Chart 1: Options prices are influenced mainly by moneyness and time until expiry.
This makes sense: an option with more moneyness (higher delta) is more likely to be exercised. Moreover, the longer the time until expiry, the greater the chance that price fluctuations will make the option “in the money.”
However, the non-linear nature of option prices makes comparing spread costs across options with the same underlying asset more challenging.
Spreads as a Proportion of Option Price
The charts below illustrate how bid-ask spreads change for options on the QQQ ETF, which is currently valued around $500.
In stock trading, it’s common to compare spreads as a percentage of the stock price. For QQQ ETF, the average 2-cent spread equates to less than 0.5 basis points (0.005%).
However, options on the same $500 stock have different strike prices, resulting in varied option prices. For instance:
- A $475 call is $25 in the money, so its extrinsic value would make it worth more than $25.
- A $525 call with one day until expiry might have a high probability of expiring worthless, potentially valuing it at just a few cents.
Even if both options are highly liquid with a 1-cent spread, that 1-cent represents a higher cost for an option valued at a few cents compared to one worth more than $25.
In Chart 2, we see:
- Out-of-the-money options have lower prices, making their spread a higher proportion of the option’s price.
- Options with less time to expiry (orange dots) lose extrinsic value, so their spread costs (in percentage) increase more rapidly.
- Options with more theta (blue dots) have prices that decrease more slowly, as there’s still a chance they might expire in the money, causing their spread cost in percentage to rise slower too.
Chart 2: Options relative spreads are higher for less expensive strikes and lower for more expensive ones.
Spreads in Cents
When considering spreads in dollar terms, we notice an almost opposite pattern. The strikes with relatively wide spreads (in percentage) are actually smaller when measured in dollars.
Chart 3: Options spreads in dollar terms follow the same trends as their prices do.
Remember that each option represents 100 shares of the underlying stock. A $1 spread is equivalent to 1 cent per share, similar to the ETF spread.
The chart shows that once an option has intrinsic value (in-the-moneyness) and delta increases, it trades with a spread more akin to the underlying stock. This is because market makers need to hedge with the underlying stock and are more likely to need to offset adverse selection when prices move against them.
Conversely, for an option with no intrinsic value and low likelihood of expiring profitably, adverse selection is much lower. As a result, spreads tighten (in cents). Short-dated out-of-the-money strikes can become very cheap (in cents).
In contrast, options with more time to expiry have a higher likelihood of eventually expiring in the money, even if currently out of the money, resulting in higher spread costs.
What Does This Mean?
The leverage of options, influenced by their moneyness and time to expiry, affects the spreads both in percentage and cents.
While we’ve often discussed the importance of understanding spread costs in stock trading, these costs tend to be more consistent over time for stocks. However, due to the multi-dimensional pricing of options (demonstrated in Chart 1, where tick constraints interact with moneyness and time to expiry), comparing spread costs for different options trades, even on the same underlying stock, is more complex. This complexity makes Transaction Cost Analysis for options challenging, if not impossible.
