Large Bid/Ask Options Spreads in Volatile Markets

New option traders may notice that bid/ask spreads widen during periods of elevated volatility. While there are several reasons for this, the main driver is often market-maker behavior. To manage risk in turbulent markets—and ensure they can still facilitate trades—market makers typically widen spreads.

Before we detail the mechanics involved, it's important to understand how market makers function and to consider other factors that influence options' bid/ask spreads.

Market makers' primary function is to create liquidity for potential buyers and sellers. To do this, they constantly quote both bid and ask prices, ensuring securities can quickly change hands without significant price changes.

Using their own capital, market makers essentially provide a counterparty for every trade, and they typically earn profits from the quoted bid/ask spread—or the small difference between their purchase and sale prices. This means their bid prices need to be low enough and their ask prices high enough so an option bought or sold at a given price will still result in a small profit on the trade for the market maker.

Of course, if bid and ask prices are too far apart, it's likely no one will want to place a trade. And when one market maker's bid/ask spreads are too wide, it can also lead others to step in to capture the trading volume. Deciding the optimal bid/ask spread to attract buying and selling, while still earning a profit, is the balance all market makers must strike.

At the same time, market makers must always manage risk and fulfill their regulatory duty to maintain orderly and fair markets. As a result of this complex balancing act, there are many factors that impact how market makers manage options' bid/ask spreads. It's not all about volatility.

Order flow and liquidity—for both underlying securities and their options—are generally the two most important determinants of bid/ask spreads. Consistent, balanced order flow and high liquidity generally lead to tighter bid/ask spreads because market makers face less risk and more competition from peers.

Meanwhile, irregular order flow and low liquidity generally lead to wider bid/ask spreads because market makers face more risk and less competition from peers. This means that even when a security isn't seeing increased volatility, spreads can still widen.

While order flow and liquidity greatly influence options' bid/ask spreads, volatility is often the most noticeable driver for traders. The volatility of both the underlying security and its option can greatly impact bid/ask spreads.

During periods of heightened volatility, spreads tend to widen as market makers manage the risks to their own options positions and trades.

Market makers typically don't speculate on the direction of an underlying security's price. Instead, they usually try to limit exposure to price moves by keeping the delta of their positions close to zero. Remember that delta refers to how much the price of an option is expected to move for every $1 change in the underlying security. Market makers primarily maintain near-neutral delta throughout the day by trading stock against the options they buy or sell. This is called dynamic hedging.

If a customer sells 10 calls, for example, the market maker will facilitate the trade by buying those calls. Since calls have positive delta, the market maker is now long delta. To remain delta neutral, they would hedge the long delta on those calls by shorting the underlying stock. (One share of short stock has a delta of –1.0.)

Consider a 0.30-delta call. When a trader sells 10 of these calls, a market maker facilitates the other side of the trade by buying them and would then be long approximately 300 delta.

To hedge this delta exposure, the market maker would sell short roughly 300 shares of stock. That way, if the stock price falls, gains on the short stock help offset losses on the long calls; if the stock moves up, the gains on the long calls offset the losses on the short stock. As shares move higher and lower, delta will always change, and market makers adjust their hedges accordingly.

Here's how this all plays into options' bid/ask spreads during periods of elevated volatility.

Prior to placing a hedge, market makers assess current stock prices to estimate what hedging will cost. If a stock is trading within a relatively tight range, a market maker may be more confident the hedge will execute near the desired price. In this case, they'll likely make narrower bid/ask options spreads to be more competitive with other market makers.

But if the stock is more volatile, the market maker is likely less confident they can execute the hedge at the desired price because orders might not get filled until the price has moved. In response, market makers often factor in potential slippage (the difference between the current stock price and the stock price at the time the market maker hedged) from their potential stock trade into the bid/ask spread of the option.

Buying the option at a lower bid or selling the option at a higher ask may potentially help protect the market maker if they get a slightly worse fill on the stock hedge, enabling them to potentially still profit on the trade—or at least better manage risk and maintain orderly markets.

The way market makers manage options' bid/ask spreads can be confusing, but for option traders, the key is to focus on how changes in these spreads can impact trading costs, execution, and even strategy selection.

When options spreads widen, whether due to volatility or other factors, transaction costs can rise, and placing trades at desired prices may be more difficult or impossible. Some traders use limit orders in order to potentially reduce costs and improve order execution when volatility spikes. Others will reduce position sizes, focus on more liquid options with narrower spreads, or even pivot to new strategies that can potentially lessen risks.

Ultimately, while understanding why the bid/ask spreads of options widen during periods of volatility can be useful, it's the net impact of these wider spreads on trading that matters most.