Today, Russ Allen, instructor at Online Trading Academy writes about what the option chain can tell us about whether trading a particular option might be too costly, in the sense that the “markup” on it is too high.

We know that the buyers of options acquire rights to purchase or to sell an underlying asset (which I’ll call “the stock”) on or before a certain date, and at a certain price. At any given moment, a single stock may have hundreds or even thousands of separate option contracts available. For example, on Oct. 23, Apple stock closed at $645.74. We could buy options on the stock of Apple that expire at any of ten separate dates in the future, from two days to 821 days out. The strike price of available options ranges from $195 per share to $1040. The options themselves range in price from one cent per share to over $450 per share. Altogether, approximately 3,000 distinct option contracts are available on Apple alone.

Although many of these 3,000 distinct contracts have never sold a single lot, there are posted prices (bid and ask) for every one of them. Whose prices are these?

The answer is that some of these bids and offers are orders placed by retail traders like us; some of them are orders from money managers and other institutions; but the vast majority are prices posted by options market makers. The market makers are option dealers. Their business is literally to buy options wholesale and sell them retail. Their markup or profit margin is the difference between the bid and the ask.

Notice in Figure 1 that on Oct. 23, the Nov ’12 calls at the $640 strike have a bid of $27.50 and an ask of $27.70. These quotes are per share. A single one of these contracts, which involves 100 shares, could be bought on that day from the market makers for $2,770, or sold to them for $2,750. The $20 per contract difference between the bid and ask is the market maker’s profit margin.

Figure 1–a Minimal Option Chain
Click to Enlarge

The amount of this margin—that is, the size of the bid/ask spread—varies based on several things, the main one being competition. If there are many traders actively buying and selling a particular contract, then the market makers will not be able to maintain wide spreads. If they try, other traders will bid more than the market makers are willing to pay, and sell for less than they are willing to sell for, thus squeezing out the spread. Conversely, if the market maker is “the only game in town,” they are free to post a wide spread, and to get large profits on those few contracts that they do buy or sell. So a lot of competition is a good thing for everyone except market makers.

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