Why Liquidity Is So Important in the Options Market

Why Liquidity Is So Important in the Options Market

Liquidity plays an important role in all markets. Some assets are highly liquid — like stocks and bonds — that investors can sell at a moment’s notice. Have an unexpected medical bill and need $40,000? No problem. If you have money in the market and need it out, you could have it that same day depending on the account and time of day. However, say you need $40,000 and the only way to get it is by tapping the equity in your home. That’s a lengthy process and will take time to get. Even worse, say you need to sell your home to raise cash. One could have their home up for sale for months — even at attractive prices — and still not get a worthy bid on the property. Real estate is an illiquid asset.

But there are subtle nuances in the market where liquidity plays a role. It connects all sorts of different dynamics, like supply/demand, volume and volatility. The options market exacerbates these principles and makes liquidity even more important. While it may be convenient to disregard liquidity, it’s a factor that investors should consider when looking to place trades in the options world. At times even, it’s best to avoid certain positions with low liquidity.

Finding the Spread

Simply put, the spread is just the bid/ask. For example, investors looking to sell at market prices would hit the “bid,” while buyers looking to buy at the market would hit the “ask.” In times of high liquidity, this spread is generally pretty tight. But as liquidity dries up, that spread widens dramatically. It makes it almost impossible to exit at a good price.

Just looking at an at-the-money call for a quick-moving company like Nvidia (NVDA). About three weeks out, the ATM call trades at $9.20/$9.45. If a trader were to buy on the ask, they’d pay $9.45. If they sell immediately, it would change hands at $9.20, plus commissions. When volatility spikes or volume declines, that spread tends to widen rather than shrink.

Say that option goes from at-the-money to in-the-money to deep-in-the-money. Rather than cashing in after making the right call, investors may face an even wider spread — even if volatility remains low. This can make exiting a position difficult given that the spread is wide and there will likely be less buyers and sellers at that particular strike. That’s due to lack of volume. Even non-volatile holdings can have incredibly wide spreads. Sometimes these spreads are as much as $1 or more, simply due to low volume. This can be especially true for deep-in-the-money options or options with far-off expiration dates. 

Liquidity and Options

It’s worth mentioning that investors don’t have to buy at the ask and sell on the bid. They can often times get a price somewhere in the middle. The lower the volume and wider the spread though, the harder it gets. For instance, if the spread is $5.00/$5.50, a $5.25 order may not go through. Instead, buyers may have to move up to $5.40 and sellers down to $5.10.

The more traders in the strike, the easier it is to get the price you want. It’s simple math. If you have 2 people on a soccer field, a perfect 50 yard pass will be difficult. If there are 10 people 5 yards apart, the passes are easier. That’s not to say investors will necessarily get the prices they want when there’s more volume — options depend on the underlying security, after all. But by having more participants, it’s one less enemy to fight on the trade.

Nothing is worse than correctly nailing a stock’s move, but not being able to get out of an options trade at the right price because we bought too high and have to sell too low. That scenario can be thanks to low liquidity and it can be a dangerous scalpel to our performance.

Combatting Low Liquidity

There’s a few ways to get an idea about liquidity. The first would be to simply look at the spread. Is it something manageable, like $1.20/$1.25? How about just okay at $3.20/$3.40? Or terrible at $5.00/$5.80?

Investors can also look at the open interest, which shows how many open contracts are currently being held by investors. They can also look at volume to get a sense of how many contracts have changed hands in the current session. When these numbers are higher, liquidity tends to be higher as well. When these numbers are low — and can be zero, for the record — then liquidity tends to be pretty tight. Keep in mind that even with lots of volume and plenty of open interest, spreads can still be wide if the underlying asset is volatile. In a nutshell, there are a lot of contributing factors to liquidity.

The smaller the move we’re looking for, the more liquidity matters. When we’re looking for larger moves, we can afford a bit more slippage in the spread (although it’s still not preferred). For tight, small moves though we need high liquidity to get in out and quickly and at good prices.

Luckily, Option Party has a few filters we can use to take advantage. Its “Stock Stats” can filter by market cap and trading volume, helping to keep potentially low liquidity plays off the radar. Minimum open interest and minimum volume in the option can help too — found under the “Options” tab. Combined with its overhauled implied volatility filters and investors can really do their best to ignore these low liquidity plays.

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