Liquidity

Trading Volume

Volume
Trading Volume. Pixabay.com

Questions from a reader:

I have a few questions on option liquidity and I hope that you can clarify:

1) Before I enter a trade, should I look at the options volume for the specific strike price that I plan to trade, to determine whether that option is liquid? Or is the open interest (OI) more important? Or must I consider both?

2) Is the width of the bid/ask spread important when thinking about liquidity?

3) If I am interested in trading a vertical credit spread and one of the options in the spread has very high volume and very high open interest, but the other option does not, would it be a good idea to look for a different spread where all the legs are liquid?

4) I see strikes with high volume, but low open interest. Does that mean that the options at those strikes are not liquid enough because the open interest is low (even though the option volume is high)?

5) Which one of the two indicators (option volume or open interest) should I be looking at before entering a trade in order to ensure that, if I need to close the position, that will happen quickly and at a fair price?

6) Are there exchange rules that limit how wide a bid/ask spread can be?

7) Is there a risk of not being able to exit some position due to lack of liquidity?

Thanks

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Low volume is not a significant deterrent for most spread traders.

However:

1) When your trade plan calls for closing the trade to limit risk, lock in profits, or roll the position to another month, then liquidity is important from the perspective of efficient trading. It is easier to get orders filled when the market makers are willing to trade at prices between the bid and ask.

When you avoid taking positions options with low volume or a small open interest, it is a safety play that may avoid trouble later -- and it is always a good idea to avoid trouble.

When your plan is to trade the options once, and forget about the position (not good risk management technique), then liquidity need not concern you.

OI on the specific strike is not important. When the OI is acceptable for the options of the specific underlying, that should be good enough to encourage making the trade. An increasing OI is more important than high volume because it suggests that there are numerous people trading the options and that not everyone is trading with the market makers. Sometimes high volume occurs for a reason unrelated to the normal trading of options. A dividend play is one example of very high volume that adds nothing to the liquidity.

2) Yes bid/ask spreads are important. However, the visible bid/ask quote on your computer monitor is far less important than the TRUE bid/ask -- and that is seldom visible (published).

At which prices are the market makers willing to trade? How far above the bid will they pay? How far below the asking price can you buy? That is what matters and you cannot get that information without attempting to trade the options, with LIMIT orders, and learning the true bid/ask spread (referred to as the 'inside market').

If you cannot get a fair price after a few trials, then give up on that underlying asset and try another. 

3) Not necessary. But please enter your order as a spread and NEVER as two single orders. If one option has good liquidity, it is almost guaranteed that the spread will have good liquidity.

4) Difficult to say. For example, if someone buys 10,000 calls and the OI remains near 10,000 for several weeks, then there is not much trading interest (volume) in that option, and I would avoid trading it. Sometimes large option blocks are traded by a pair of professionals and neither market makers nor individual investors take part in the trade -- making the high OI meaningless. If the market makers want to trade with you (i.e., public customers), they will have good inside markets.  If other customers don't want to trade, there will be low volume.

This OI is more important.

Because you don't know the mindset of the market makers, you can only discover the truth by entering LIMIT orders.  When you discover poor quality markets, cross that underlying off your list.

5) You cannot get that guarantee. If bad news hits, bid/ask spreads widen and no matter how high the quality of previous markets, the market makers may back away from trading, leaving you poorly placed when attempting to exit or adjust. When either OI or Vol is high, you have a better chance of being able to get out at a reasonable price. 

6) Yes, there are limits. However, for the life of me I cannot understand how bid ask spreads can be as wide as they are. The exchanges allow so many exceptions to the rules, and I believe that the rules have been ignored for years. To find out the official rules, you can ask that question: options@theocc.com

7) The truth is simple:  If the market markers become unwilling to trade – and that should be very rare – there is nothing you can do. Thus, good OI numbers and good volume give you a hint of how easy it is to trade when necessary,  but unusual circumstances (flash crash for example) may result in any options becoming difficult to trade.

Keep this in mind:  If you are a small trader who is attempting to trade 5-lots, you need not be too concerned with any of this.