Lesson 11 of 20 · 6 min

The bid-ask spread is a real cost

You transact at the bid or the ask, never at the middle, and the gap is paid on both ends.

A quote has two prices. The bid is what someone will pay you; the ask is what someone will charge you. The distance between them is the spread, and it is a cost that does not appear in any commission schedule.

The midpoint is a convenient reference and is not a price at which anyone has committed to trade. Displayed marks and profit-and-loss figures are often computed from it, which means a position can appear to be worth more than it can actually be closed for. Entering and exiting each cross some part of the spread, so the round-trip cost is roughly the full spread, not half of it.

What makes option spreads worth specific attention is proportion. A stock trading at $50 with a one-cent spread costs two basis points to round trip. An option quoted $0.90 bid at $1.10 ask has a twenty-cent spread on a dollar contract — a round-trip cost of about twenty percent of the position's value. The same absolute spread is trivial on the stock and enormous on the option, because the option's price is small.

Spreads also widen exactly when they are most costly: at the open, in fast markets, on far out-of-the-money strikes, and on contracts with little open interest. A cost that grows during stress is a different kind of cost from a fixed fee, and it is the mechanical reason liquidity is the subject of the next lesson.

Key terms

Bid and ask: The best price at which someone will currently take the other side. Bid to sell into, ask to purchase from.
Spread: Ask minus bid. The immediate cost of transacting, paid on entry and again on exit.
Midpoint (mark): The average of bid and ask. Used for display and valuation. Not a price anyone has agreed to trade at.
Slippage: The difference between the price you expected and the price you received.

Worked example

A twenty percent cost with no fee attached

A contract quoted $0.90 bid, $1.10 ask. One contract, 100 shares.

Midpoint: $1.00
Cost to open at the ask: $110
Proceeds to close at the bid: $90
Round-trip spread cost: $20
Price move needed just to break even: $0.20 in your favour
Same $0.20 spread on a $50 stock: 0.4% round trip

Identical spread, fifty times the proportional cost. On low-priced contracts the spread is often the largest single cost of the position.

Check yourself

A contract is quoted $0.90 bid, $1.10 ask, and your platform marks your position at $1.00. What does it actually cost to open and close, and how far must the price move before you break even?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.