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Bid vs. Ask: What You Need to Know About Options Trading

26 June 2020 No Comment

Investors can make money on the stock market through a variety of different types of funds, stocks, and styles of trading. Options trading is one of the more complicated types of stock trading, but it can yield huge rewards. When learning how to trade options, it’s invaluable that you understand a few specific terms like ask, bid, and bid-ask spread.

What Is Options Trading?

Options trading is more complicated than traditional stock trading. Normally, an investor purchases stock shares at a set price, holds them for as long as they wish, and then sells them, hopefully at a profit. However, in options trading, the investor purchases a contract rather than a specific stock that gives the owner of the contract the right (but not the obligation) to purchase or sell some or all of the associated asset at a pre-determined price before the contract expires.

Investors use options trading for a variety of reasons, but most commonly to increase income and portfolio protection. While options trading can offer a substantial reward, it does come at high risk. It’s important to understand the specifics of the contract when purchasing an option to ensure you know what’s at stake.

What Is Bid vs. Ask?

Bids and asks are terms used to describe the pricing of stocks during trading. Buyers, also known as investors, make bids indicating the highest amount of money they’re willing to pay for a stock share. Sellers, also known as market makers, place asks, or the lowest amount of money they’re willing to sell the stock share for. Almost always, the ask price is higher than the bid price, resulting in a difference called the bid-ask spread.

What Is Bid-Ask Spread?

The difference between the bid and the ask is known as the bid-ask spread. Stockbrokers and other industry professionals often assist with complicated trades, and so they keep the spread between the bid and the ask as payment for their services. The bid-ask spread can be small or large, depending on the liquidity of the company and stock.

High-liquidity stocks are those that trade frequently, resulting in an easy connection between buyers and sellers. Since there are so many people eager to make trades, stockbrokers can easily match investors and market makers. Low-liquidity stocks, on the other hand, trade much less frequently. It takes more labor to match investors and market makers for these trades, meaning the spread is usually larger and the payoff greater for stockbrokers.

Tips for Investing

Keep these tips in mind when embarking on options trading:

  • Understand the risk. Options trading is much riskier than traditional stock trading and can result in considerable losses. Make sure you understand the stakes before getting started.
  • Use volatility to your advantage. A volatile stock market can actually lead to increased rewards in options trading.
  • Consider any dividends. If the stocks within your options contract include dividends, understand how those contribute to the overall value of your contract before making any moves.

The possible rewards of options trading often outweigh the potential risks. Be sure you truly understand how options contracts function before embarking on trades.

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