Putting it all together: bid, ask and last prices

Question

I have recently started to trade options and am having trouble putting together the bid, ask and last prices. Let me tell you where I am currently at and please correct me if I got anything wrong.

• The ask price is the best price available to buy at while the bid price is the best price available to sell at
• The last price is the price at which the last transaction of a security took place
• Bid/ask prices come from market makers who offer to buy and sell at the ask/bid price instantaneously
• When I wish to buy on option, then I can either choose the current ask price as limit and have my order filled immediately or I choose a lower limit in the hope that the ask price will fall enough so that my order is filled

About the last one, I am not so sure. Do I really have to buy/sell at the ask/bid price? Or is it possible that transactions take place below/above the ask/bid price? Who would then be at the other end of the trade, a market maker or another trader?

Do bid/ask prices only reflect the best offers by market makers so that individual traders who might sell for lower/higher who do not influence bid/ask prices exist in the market? Is it possible that another trader is at the other end who might bid/ask different prices than the given bid/ask prices from market makers so that I can sell between the bid/ask spread?

What I am further having trouble with is reconciling the bid/ask spread with the last price. It is the last price a transaction of the security took place. But if that was entirely true, then me buying at the ask price or selling at the bid price would also be a transaction of the option that took place. How come it does not just switch between the current bid/ask prices all the time?

Furthermore, the last price always lies somewhere between bid and ask price. How did, whoever was involved in that last price transaction, buy or sell at this price whereas I can only buy at the bid/ask price? How can I buy/sell at prices between the bid/ask price?

Thank you very much in advance. These are probably rookie questions but I am really confused.

Answer 1

The ask price is the best price available to buy at while the bid price is the best price available to sell at

This is true. Another way to look at it is that the ask price is the lowest price at which sellers are willing to sell their stock and the bid price is the highest that buyers are currently willing to pay for the stock.

Bid/ask prices come from market makers who offer to buy and sell at the ask/bid price instantaneously.

This is true if the market maker is the only participant. If you place a higher bid to buy or a lower offer to sell then you become the market on that side until either your order is filled or someone places an order with an even better price, leaping in front of you.

When I wish to buy on option, then I can either choose the current ask price as limit and have my order filled immediately or I choose a lower limit in the hope that the ask price will fall enough so that my order is filled. About the last one, I am not so sure. Do I really have to buy/sell at the ask/bid price? Or is it possible that transactions take place below/above the ask/bid price? Who would then be at the other end of the trade, a market maker or another trader?

Suppose the quote is $2.00 x $2.25. Trading at the market means buyers pay $2.25 and sellers receive $2.00. If you place an order to buy at $2.10 then the quote becomes $2.10 x $2.25. Any seller willing to transact at $2.10 will take the other side of the trade. He could be a trader or he could be the market maker.

If it's a must have order, you must pay the ask to buy or accept the bid to sell. If you wish price improvement (like raising your bid to $2.10), you must wait for a counterparty to trade at your price. If one does not show up then you risk missing the trade (the quote moves up to $2.50 x $2.70).

Do bid/ask prices only reflect the best offers by market makers so that individual traders who might sell for lower/higher who do not influence bid/ask prices exist in the market? Is it possible that another trader is at the other end who might bid/ask different prices than the given bid/ask prices from market makers so that I can sell between the bid/ask spread?

In the US we have NBBO (National Best Bid Offer). Anyone who offers price improvement improves the quote and narrows the bid/ask spread.

What I am further having trouble with is reconciling the bid/ask spread with the last price. It is the last price a transaction of the security took place. But if that was entirely true, then me buying at the ask price or selling at the bid price would also be a transaction of the option that took place. How come it does not just switch between the current bid/ask prices all the time?

Stocks whose options do not trade frequently often display stale prices. Using the previous quote of $2.10 x $2.25, someone buys the call at $2.25. The stock moves up, as does the call's price and the current quote might be $2.50 x $2.80 with a last trade of $2.25.

A general rule of thumb is that the chances of getting a fill on an option order is reasonably good if you split the bid/ask. IOW, if the quote is $2.50 x $2.80 then you have a good chance at buying or selling at $2.65. There are some stocks where you can get midpoint or better frequently. There are other stocks where the market maker won't give even a nickel of price improvement even with a 20 or 30 cents wide B/A spread. Liquidity plays a large role in this.