The Importance of Option Liquidity

The Importance of Option Liquidity

Liquidity in trading is an indication of how easy it is to buy a sell an instrument. When trading stocks, it is important. However, the volume for equities is usually much higher than the volume for options. So, liquidity is not as much of an issue for stocks and ETFs as it is for trading options.

Liquidity is important for options traders because it impacts the speed and the price at which you can execute a trade.

Options traders will often look at the volume and open interest to assess the liquidity of an option. This is a good indication. However, there is a more effective measure by considering the options pricing, itself.

Traders can buy at the bid price and sell at the ask price. (If you ever get confused by this, just look at the pricing and remember you get the less favorable end of that transaction. The bid price is always lower than the ask price.)

On your broker’s platform, there’s an option to display the bid size and ask size. These are the number of contracts that are available to be traded at the corresponding bid and ask prices. That is good information to know, but not a direct reflection of liquidity.

Traders don’t want to trade at the bid or ask. They are always trying to get a better deal. Often times, it is possible to get a trade filled at a price somewhere between the bid and the ask price. Halfway between the bid and the ask prices is the “mid” price. Many traders will place a trade at the mid price, hoping to get filled. Then, they will move closer to the ask if they are buying or closer to the bid if they are selling. This is a sort of “price discovery” to see where the market is actually trading.

Timing becomes an issue when you are trying to place a trade and the market is moving. A trader may place a trade – somewhere between the bid and the ask – and not get filled. Then the trader has to chase the trade as the underlying equity is moving. This normally does not result a favorable situation for the trader.

Probably the best indication of liquidity is considering the difference between the ask and the bid, relative to the price of the option. The difference between the ask and bid price is called the “bid/ask spread.”

When you are trading at the bid or ask price, you are probably trading directly with the market maker or specialist. They have the benefit of buying at the bid price (the lower price) and selling at the ask (the higher price.) That is their fee for creating the market.

When there is less volume, the market maker will widen the bid/ask. They need to get paid to create the market. They either make their money with a wide bid/ask spread – on a low volume instruments – or from the high volume of transaction on instruments with a tight bid/ask spread. Of course, the market maker would prefer to always keep bid/ask spread wide. When the volume becomes higher, there are more traders who may be willing to take less favorable price than the market maker. That causes the bid/ask spread to tighten.

The bid/ask spread is important to your profitability. Just opening and closing an option, you will lose the difference between the bid and the ask. This is sometimes referred to as slippage. To make a profit, you need the option to rise above the bid/ask spread, just to break even.

To get an objective measurement of the liquidity, traders should consider the following evaluation.

  1. 1) Identify the at-the-money strike (that is the option strike that is closest to where the stock is trading.)
  2. 2) Chose the ATM call option that is 3 or 4 weeks before expiration.
  3. 3) Subtract the ask price from the bid price and divide that by the bid price. (ask-bid)/bid X 100%

Following are the guidelines for evaluating the result:

Excellent liquidity: 2% or less

Fair liquidity: 4% – 6%

Poor liquidity: 10% or higher

When the liquidity is less than 2%, the trader will be sacrificing less profit and also has confidence that their trade will be filled in timely manner. Options on equities like AAPL, SPY, GOOG, etc. typically fall in this range. When the liquidity is poor, the trader has to deal with not only less favorable entry price, but they may find themselves in situation where they are losing money on trade that would have been profitable – if not for the wide bid/ask spread.

In some cases for options with poor liquidity, it’s not uncommon to see the bid/ask spread be wider than the bid price itself. In situations like this, it is practically impossible to make a profit on those options. The market is tough enough without having to fight that battle.

Traders would be wise to consider equities with good options liquidity when building a watchlist.

Eric Hale
OptionsANIMAL Instructor

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