An option is a contract between a buyer and a seller. Because of this, a common question from new option traders is, "Who exactly is buying from me or selling to me?" While it's of no consequence to the outcomes of your trades, understanding who is buying and selling can help you understand how the options market works.
Market makers
Let's take a moment to answer this question: When you buy or sell an option, who is on the other side of that transaction? The answer is a market maker.
The job of a market maker is to facilitate the trade. However, this doesn't always mean that market makers take the other side of the trade and are bearish when you're bullish, or vice versa. In fact, in most cases, their goal is to not have to hold the other side of the trade (though they will if no other traders are interested). Instead, they aim to match buyers with sellers, so they don't have to take the other side and the additional risk. To achieve this, they change the price of options up or down to make the other side more attractive to prospective traders.
Because market makers are always there to buy or sell options, they can be seen as an economic good. To understand this, put yourself in the shoes of a portfolio manager. Suppose you need to buy a particular options contract to manage the risk of your portfolio. It's beneficial to you that there is someone out there willing to make a deal with you and offer you what you're looking for. Of course, if you're asking for something that isn't widely traded, the price may not be favorable.
Bid/ask spread
While market makers are an important part of a well-functioning financial system, they're not a charitable organization. There's money in it for them too. Market makers make money from the bid/ask spread. When market makers list the prices of an option, they set a bid, or buying price, and an ask, or selling price. Their goal is to find a buyer who's willing to pay the bid and a seller who's willing to accept the ask, and then match them up. The difference between the bid and the ask, known as the bid/ask spread, is the market maker's cut, or the cost of their services.
The bid and the ask are a function of supply and demand. If more people are willing to buy and sell options, competition for prices increases among market makers. Traders talk about volume when measuring trading activity. In the options market, volume is measured by the number of contracts traded. Higher trading volume typically results in narrower bid/ask spreads. A market with high volume and narrow spreads is often called a liquid market. Liquidity is good for option traders because it reduces the bid/ask spread and gives traders more confidence that they'll be able to find a buyer or seller at a desirable price.
In your own trading, it's worthwhile to factor in the bid/ask spread and the liquidity of an option. A large bid/ask spread can greatly impact your potential profit or loss. For example, assume there's an option with a bid of $1 and an ask of $1.50. Consider what would happen if you immediately bought and sold the trade at those prices—you'd be down $0.50 (a loss of more than 30%) without the options price moving at all. In order to be profitable, the options price would need to appreciate in value considerably just to cover the bid/ask spread. Now, assume there's an option with a bid of $1 and an ask of $1.02—this is a much smaller bid/ask spread and probably a sign of greater liquidity. If you immediately entered and exited the trade at those prices, you'd only be down $0.02, which is a loss of roughly 2%.
As you'll see later when we demonstrate strategies, it's important to always check the bid/ask spread and the volume to ensure that your option has sufficient liquidity.
Please note that in the options market, there is no absolute guarantee of being able to close out of any options position. For example, a call option could have a strike price so far above the stock price (or a put option with a strike price so far below the stock price) that nobody wants to purchase it. Or if trading on the underlying stock has been halted, the trading of its options will also be halted.
One factor that impacts how market makers price options is volatility. In the following video, Education Coach Cameron May explores a volatility index known as the VIX®, which is used by market makers and individual traders to measure volatility and make trading decisions.
