We have spent a lot of time talking about ticks, spreads and trading costs in the equities markets.
Today, we take a look at options trading. As we know, options markets are very different to stocks – and their spreads are no exception.
Options prices driven by option Greeks
Black-Scholes was revolutionary in helping to price options. It quantified how things like time until expiry, moneyness (how far the strike is from the underlying price) and volatility all work together to determine the fair price of an option.
In the options markets, we see how that works by looking at real prices. As Chart 1 shows, options that are more in the money (delta) have higher prices. In addition, options with more time to expiry have higher prices.
Chart 1: Options prices are largely determined by the option’s moneyness and time to expiry
That should all make sense — an option with more delta (moneyness) is more likely to be exercised. In addition, the longer we have until expiry, the higher the chances that prices change which could put the option “in the money.”
However, this “non-linear” nature of option prices makes it even harder to compare spread costs across the same option underlying.
Spreads as a proportion of option price
In the charts below, we show how bid-ask spreads evolve for options on the QQQ ETF, currently around a $500 ETF.
When looking at trading costs for stocks, it’s pretty common to compare stock spreads as a percentage of the price of the stock. For the QQQ ETF, the 2-cent average spread is equivalent to less than half (0.5) basis-point (or 0.005%).
However, because options on that same $500 stock have very different strikes, they also have very different prices. For example:
- A $475 call will already be $25 in the money, its extrinsic value should make the option worth even more than $25.
- But a $525 call with one day until expiry has a high probability of expiring worthless, so might be worth just a few cents.
Even if both options are highly liquid, with a 1-cent spread, that 1-cent will be a higher “cost” for an option worth a few cents, compared to an option worth more than $25.
In Chart 2, that’s exactly what we see:
- Out of the money options have lower option prices, so their spread becomes a higher proportion of the options price
- Options with less time to expiry (orange dots) lose extrinsic value, so their spread costs (in percent) increase faster.
- Interestingly, options with more theta (blue dots) have prices that decrease more slowly, as there remains a chance they ultimately expire in the money. That makes their options spread cost in percent increase slower, too.
Chart 2: Options relative spreads are higher for less expensive strikes and lower for more expensive ones
Spreads in cents
When looking at spread in dollar terms, however, we see almost the opposite pattern. The strikes that were relatively wide (in percent) are actually smaller (in dollars).
Chart 3: Options spreads in dollar terms follow the same trends as their prices do
Remembering that each option represents 100 shares of the underlying stock, a $1 spread is the same as 1-cent per share, which is similar to the spread on the ETF.
What the chart shows, is that:
- Once the option has intrinsic value (in-the-moneyness), and delta increases, it trades with a spread more like the underlying stock. This makes sense given market makers will need to hedge with the underlying stock and are more likely to need to offset adverse selection when prices move against them.
- However, for an option that has no intrinsic value and is unlikely to expire with any profit, adverse selection is much lower. As a result, spreads actually tighten (in cents). At the most extreme, short-dated out-of-the-money strikes quickly become very cheap (in cents).
- In contrast, options with more time to expiry are more likely to expire in the money, even if they are out of the money now, and so their spreads costs are higher.
What does this mean?
It’s interesting to see how the leverage of options, caused by their different strikes (moneyness) and time to expiry, changes the spreads (in percentage and cents).
As we’ve discussed in the past, spread costs can be important to understand stocks trading costs. However, with stocks, the cost of trading each ticker is fairly constant over time. What we see here is that, because of the multi-dimensional pricing of options (shown in Chart 1, where tick constraints combine with moneyness and time to expiry), it makes comparing spread costs on one options trade difficult to compare to another trade in an option, even in the same underlying stock. That makes Transaction Cost Analysis for options much more difficult (some might say impossible).