I’ve touched on a lot of important aspects of the trading environment in my posts. The Greeks, trading small, trading often, volatility… but none of this matters unless we have a market that we can actually TRADE in.
We can’t buy options if no one is willing to sell them to us. Likewise, we can’t sell options if no one is willing to buy them from us.
That’s where liquidity comes in.
Liquidity can be measured by a number of different things, including open interest, volume, and the bid-ask spread. The bid-ask spread is the easiest one to glance at and determine whether or not the underlying is liquid, but volume tells us a good story as well.
Open interest is the number of option contracts outstanding on a particular stock. So when someone sells a put or buys a call from someone else (any movement of options), that creates an open contract. Volume is the number of contracts traded per day- it tracks the number of transactions that are completed.
So when we look for liquid underlyings, we look for stocks that trade over 1 million shares per day. When we are just looking at option strikes, we like volume to be 1,000+. That allows us to get in at a fair price. The more option contracts that are traded, or the more shares traded, the narrower the bid-ask spread is, which gives us that fairer price.
The bid price is the price that the market is willing to buy at, and an ask price is the price that the market is willing to sell at. The bid-ask spread is the difference between these two prices. We want to have the tightest spread as possible, because that means there are a lot of market participants, which means we are more likely to get a fair price.
The more action there is on each side, the more the spread gets pushed together. A very tight bid-ask spread would be about a 1 cent difference, so a bid price of $0.30 and an ask price of $0.31. A large spread, for example, would be a bid price of $0.30 and an ask price of $0.60- a spread of $0.30.
What’s wrong with that? Why do we prefer a tight spread over a large spread?
If you got filled on a large spread trade, there’s a possibility you might be locked into on the trade. If you sell a put, and if there isn’t a lot of market participation, there might not be anyone willing to be the second party to that trade. We need at least 2 people for a trade to be successfully executed. When we only have one person, we simply can’t execute the trade.
If you place a trade in an illiquid underlying, and things start going south, there’s a big chance that you won’t get out of it without quite a few dents in your total profit. When you move into liquid stocks, you are able to get out of the trade quickly and efficiently when things go bad (and when things go well!) which is helpful, both for profit AND loss purposes.
Getting a fair price for a trade can be a frustrating process in itself. I remember when I was placing a credit spread in a pretty illiquid stock, but I was super happy with the amount of credit I was getting. But because the market was so illiquid (the bid-ask differential was at least $0.30) it took FOREVER to get filled, and I had to keep lowering the credit I was willing to receive.
Because I was so impatient (and stubborn), I lost about $10 in credit. By the time I was ready to get out of the trade, in order to get filled, I had to raise the price I was willing to buy it back at. Basically, all that credit I thought I was going to receive disappeared into the deep depths of illiquidity, never to be seen again.
Now when I place trades, I look for really tight bid-ask spreads. I’m pretty picky, so I like a spread of no more than $0.02 cents. Large bid-ask spreads can be a sign of ominous things to come, so it’s better just to stay out of them altogether. When we see the spread suddenly become very wide, that’s a definite red flag that the market might be predicting a drop in the underlying’s price.
Overall, LIQUIDITY IS EXTREMELY IMPORTANT. So important, and so vital, that sometimes we forget to mention it. 🙂 Pay attention to how much the contract or underlying is being moved around. Just to reiterate, we want 1,000+ movement in contracts per day, and at least 1 million shares. This helps keep potential profits safe from the illiquidity leak, and keeps things nice and fluid!
Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.