Liquidity: Does it make a difference when trading options?

Hi Mark,

I was wondering if you think a lot of the liquidity in some options has started to dry out, or that they are moving up the spreads [bid/ask spread] in some options?

I remember as a kid back in mid to late 90's, there was a lot more liquidity in some options and the spreads were better. And over the last few years some of the liquidity in options seems to be disappearing. Not including the big guys, like the mid-cap or small cap company options.

Is it because a lot of the market makers are being hurt by the new rules, increase volatility, or that a lot of market makers are being taken out of the markets. I know that the biggest option maker citadel has been hurting a lot over the last couple of years, and smaller hedge funds who pretend they're market makers are being taken out.

So are we heading back my dads time of 80's option type market, with just the quick access? Also is there any trade magazines you could recommend about the options industry.

Thank you

Jason M

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Ah youth!  'Your dad's time in the 80's.'  I traded my first option in 1975.

The truth is that I have not noticed such a decline in options liquidity.  But I am not the right person to ask.  I trade index options, and they are very liquid.  The bid/ask spreads are very wide, but the true market is much narrower. 

It's true that liquidity may have dried up in the places where it was thin to begin, but I cannot corroborate your feelings.

Today the trading world is so different that neither your dad nor I would recognize it.  The trading is electronic.  The days of competitive market makers shouting bids and offers is either gone, or disappearing.  There are still orders coming from individual investors, but all the big orders are shopped off the floor before the market makers ever know that such orders exist.

And market making is a different game.  There are few independent market makers these days.  I don't believe they have been hurt by any new rules. 

These floor traders are the employees of large trading firms.  they take down the trades – hopefully by paying the bid or selling the offer and they have no further responsibility to hedge the trade.  Their partners, manning powerful computers find the appropriate hedge for the entire trading firm's portfolio.  They stay as neutral in as many of the Greeks as possible – most of the time.  I have no idea if they ever they take more risk for greater rewards because such information would be closely guarded.

I don't know the Citadel story, other than they made some bad moves.  Did they get hammered in the options markets, or did they take too much risk – and it's the risk coming home to roost that hurt them?  I strongly suspect it's the latter.

It's true that some hedge funds have trading privileges, just like the market makers.  That's also a new innovation.  I believe if they manage risk carefully, they have an inside track to make money.  If they take risk – or base their hedging rules on ideas that go astray, then yes, they can get clobbered also.

If I were running such a hedge fund, I'd keep my strategies as simple as possible.  Chasing extra reward in a world in which so many have gone broke is folly, in my opinion.

Trade magazines.  No, I don't read or know about those.  I do look at a few trading magazines.

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