Understanding Option Trading Spreads (part 2)

The tighter the option trading spread is the better things are going to be for you. However tight spreads are only meaningful when they are paired up with good execution. Quality of execution will decide whether you actually receive tight spreads. A good example of this is when your screen shows a tight option trading spread, but your trade is filled a few pips to your disadvantage or is mysteriously rejected.

When this occurs repeatedly, it means that your option trading broker is showing tight spreads but is effectively delivering wider spreads. Rejected trades, delayed execution, slipping, and stop hunting are option trading strategies that some brokers use to get rid of the promise of tight spreads.

option trading spreads should always be considered in conjunction with depth of book. Oddly enough, when it comes to economies of scale, option trading doesn't even act like most other markets. On the inter-bank market, for example; the larger the ticket size, the larger the spread is. So when you see a 1-pip spread on an ECN platform, you have to wonder if that spread valid for a $2M, $5M or $10M trade, which it probably isn’t. In many cases, the tight spread that is offered applies only to a capped trade sizes that are very inadequate for most of the common trading option trading strategies.

Spread policies change a great deal from broker to broker, and the policies are often difficult to see through. This certainly makes comparing option trading brokers much more difficult. Some option trading brokers actually offer fixed spreads that are guaranteed to remain the same regardless of market liquidity. But since fixed spreads are traditionally higher than average variable spreads, you are paying an insurance premium during most of the trading day so that you can get protection from short-term volatility.

Other option trading brokers offer traders variable spreads depending on market liquidity. Spreads are tighter when there is good market liquidity but they will widen as liquidity dries up. When it comes to choosing between fixed and variable option trading rates, the choice depends on your individual trading pattern. If you trade primarily on news announcements that you hear, you may be better off with fixed option trading spreads. But only if quality of execution is good.

Some option trading brokers have different spreads for different clients based on their accounts. For example; those clients that have larger accounts or those who make larger trades may receive tighter spreads, while the clients that are referred by an introducing broker might receive wider spreads in order to cover the costs of the referral. Some offer the same option trading spreads to everyone.

Problems can come up when you are trying to learn about a company's option trading spread policy because this information, along with information on trade execution and order-book depth is rather difficult to get. Because of this, many traders get caught up in all of the promises they hear, and take a broker's words at face value. This can be dangerous. The only real way to find out is to try out various option trading brokers or talk to those who have.