The transaction costs in option market could be quite large. The bid ask spread of a SP500 firm could be around 15% of the mid-quote when I check the data. Since I do not have data on transaction price, I wonder how far away the actual traded price could be from the mid-quote for a SP500 firm. And usually how much the transaction cost could eat away the profits of an option strategy? Half of it? Or it could be even higher?
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2 Answers
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I am afraid there is no general rule, it will depend strongly on who the market maker is in that series. By experience, your actual hits will be much closer from the theoretical mid you deduce from the bid/ask, knowing that the true mid could be completely different.
Let's take an example where you can have a bid/ask displayed @ 0.20/0.80 (which should imply a mid at 0.50). However the true levels (where you will get hit if you put a limit order) could be either.
- 0.45/0.55 (centered on mid but narrower)
- 0.40/0.55 (not centered on "theoretical" mid)
- 0.33/0.42 (offer is actually below the "theoretical" mid)
- 0.20/0.80
It will depend on how far you are from the money (displayed deeply ITM/OTM options quotes are just a joke), how popular the stock is, what is the market maker inventory/bias. If you can get tick data graphs, you will see the algos widening/narrowing the bid/ask or hitting orders, this should give you an idea. Know that if you get hit immediately, you're probably leaving money on the table.
It's also probably better to think in terms of points of vol. wide rather than percentage of premium.
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Undoubtedly, transaction costs in options are large. However, measuring these transaction costs as a percentage of the option value may overstate the situation. Options have leverage ($\lambda$), so a small amount paid for the option can control a much larger sum of the underlying stock. If you were to measure transaction costs as half the bid ask spread of the option divided by the value of the delta equivalent amount of stock, you would have, in my opinion, a fairer way of measuring the transaction cost. Note that if you buy an option and hold it to maturity you do not have to incur the cost of selling.
Is it possible to make money on an option despite a 15% bid-ask spread? We have all seen situations where the option doubles, triples, etc. in a short time so it is certainly possible. But clearly an active strategy that constantly buys and sells options is not to be recommended. The fact that the most liquid options are 1 month, 2 months, 3 months worsens the problem by increasing the frequency of trading. (No wonder options are popular with brokers).
