Options Liquidity - Introduction
Liquidity of a publicly traded asset has always been of utmost concern for not only stock traders but all kinds of investors, even investors in art or properties. Liquidity refers to how "liquid" an asset is. A highly "Liquid" asset will "flow" from hand to hand easily and readily while an "illiquid" asset may flow slowly or even have no buyers to flow to. The issue of liquidity is a fairly straight forward one in stock trading but is extremely complex in options trading. Determining liquidity of options contracts is truly one of the trickiest issue in options trading. So, how is options liquidity determined?
This free options trading tutorial shall explore in depth what liquidity means and how liquidity of an options contract can be determined.
What Exactly Is Liquidity?
The term "Liquidity" comes from the word "liquid" and is a very widely used investment terminology. Liquid flows from one spot to another and liquidity refers to its state of "liquidness". This is used in investment to refer to the ease and frequency at which an asset "flow" from one investor to another. An asset is referred to as "Highly Liquid" or has a "High Liquidity" when it is heavily traded and has a ready market with ready buyers and sellers. On the other hand, an asset is referred to as "Illiquid" or has a "Low Liquidity" when it is rarely traded and has little or no ready buyers and sellers. Basically, when you own an asset of high liquidity, you will find it easy to sell the asset for cash at a readily established market price. However, when you own an illiquid asset, you might find it nearly impossible to find a buyer to sell to and even if you do, the buyer won't be likely to buy the asset from you at the "market price" but rather at a much lower price depending on how eager you are to sell.
Even though all investors seem to understand what liquidity means and which assets or stocks have better liquidity, it remains more of an art than a science to measure the liquidity of an asset. Stock traders typically use ballpark figures such as average daily trading volume of 200,000 to qualify a stock as liquid enough for trading. However, unlike stocks, simply depending on the trading volume cannot tell you how liquid an options contract is. In fact, many options contracts of good liquidity may actually have little to no trading volume in a single day. Determining options liquidity can be extremely tricky for options beginners. So, how can one tell the liquidity of an options contract?
Why Volume Traded Is Not a Good Indication of Options Liquidity
As mentioned above, the best indication of liquidity for stocks is the traded volume itself but that logic does not necessarily apply to options. Why is that so? The reason is that options will never be as heavily traded as stocks due to the fact that there may be up to a hundred different options contracts available for a single stock, spreading out the trading volume for that stock's options thinly, mainly between options that are near the money. Also, options do not need to be traded for their value to change as the value of options move with price movements in the underlying asset. As such, a low traded volume for options may not suggest that an options contract is illiquid because most options contracts will have low traded volume. In fact, it is possible for most options contracts to not have any traded volume for the day and still have good liquidity. This is why many options traders turn to another piece of options information known as "Open Interest" as indication of liquidity.
Why Open Interest Is Not a Good Indication of Options Liquidity
A lot of options traders deem options with high open interest to be highly liquid. Open interest is the total number of outstanding contracts held in the market that has not been closed. An options contract with open interest of 900 has 900 contracts still being held by options traders that has yet to be exercised or closed. Of course this means that an options contract with a high open interest is one that has been heavily traded and would suggest a high liquidity. However, are options that have little to no open interest necessarily illiquid? Not at all. All options contracts start with absolutely zero open interest and gradually build up open interest the longer it stays available in the market. Highly liquid in the money or out of the money options contracts usually also have a much lower open interest than their at the money counterparts but they can still be as liquid as options with a high open interest. Also, many actively day traded options contracts are heavily traded during market hours but closed by the end of the day, resulting in a low open interest as open interest is not cumulative. This is why immediately discounting low open interest options as being illiquid isn't completely correct either. So, if low volume and low open interest does not necessarily mean a lack of liquidity, does that mean that there's no such thing as an illiquid option?
Options Can Be Illiquid As Well
Yes, options can be illiquid as well. Options become illiquid when market makers find it too risky to take a position in a particular option due to lack of interest in that option. Surprise surprise, options traders are not really trading options with other options traders in the options market. All options traders are trading against professional market makers that are charged with the duty to make market and maintain liquidity for all options contracts. These market makers stand ready to buy or sell options at all times, thereby guaranteeing liquidity for all options contracts. This is particularly so for stocks that are very heavily traded like the QQQ. Yes, if the underlying stock has good liquidity, chances are that its options would be highly liquid as well. So, what are illiquid options contracts like?
Illiquid options will be extremely hard to sell at a price that contains any extrinsic value. This means that even if the underlying stock did move in the favor of your options contract, you might find it impossible to sell that options contract at all at the higher price unless you are willing to sell at an extremely low price. In fact, you might not be able to sell an illiquid option that you bought at all and may have to hold it all the way to expiration. So, how can we tell if an option may be illiquid? If volume and open interest are both not good indicators of an options liquidity, what is the definitive way to gauge the liquidity of an options contract?
Best Indicator of Options Liquidity
Lets recall that in options trading, it is really market makers that are acting as the counterparty to your options trade. This then translate to options liquidity simply being the willingness of market makers to take on the other side of your options trade! The more willing and eager market makers are to buy an options contract from you or sell to you, the more liquid that options contract becomes. So, how do we tell if market makers are eagerly buying and selling a particular options contract?
The more market makers are competing to buy and sell an options contract, the more liquid an options contract becomes. This shows up as the bid ask spread in the options chains. Ask price is the price at which a market maker is offering to sell you an options contract and the bid price is the price at which a market maker is offering to buy that options contract from you. If a market maker is offering a much higher price to sell you an options contract but offering to buy back immediately at a much lower price, this tells you something about the willingness of that market maker to trade that particular options contract and hence the liquidity of the options contract.
As more market makers compete to buy or sell an options contract, the narrower the bid ask spread of the options contract becomes as market makers sacrifice potential bid ask spread profit in order to secure a buyer or seller. Yes, market makers compete with each other for trades and deals as well. As such, the narrower the bid ask spread of an options contract, the better its liquidity will be even if it has zero volume and next to nothing in terms of open interest. Highly liquid options can sometimes have bid ask spread as narrow as $0.05 and illiquid options contracts can have bid ask spread as wide as $1.00 or more. Yes, the bid ask spread of an options contract is the best indicator of options liquidity.
As such, an options contract with high volume, open interest and narrow bid ask spread is the best guarantee of liquidity you can have. As a rule of thumb, a bid ask spread of within 10% of the ask price is good enough indication of liquidity. Options on stocks that are heavily traded also tend to be very liquid with good bid ask spread.
Must an Options Trader Always Be Concerned With Options Liquidity?
No, not all options traders need to be concerned with options liquidity in options trading. Unlike stocks, options are derivatives that can eventually be exercised for their underlying assets even if they are not sold. This means that if you buy an option with the intention of eventually exercising it for the underlying stock or letting it expire worthless if it didn't perform, you don't have to be concerned with how liquid the option is at all because you don't have to sell that options contract away at all. In fact, if you hold illiquid in the money options all the way to expiration, they still get automatically assigned by expiration so you won't get stuck with them indefinitely. However, that being said, illiquid options tend to have higher amounts of extrinsic value on purchase than options with higher liquidity so options traders looking to buy and hold such options contracts should take the higher extrinsic value into consideration.
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