I have a few questions on option liquidity that I was hoping you could clarify for me:
1) Before I enter a trade, should I look at the options volume of the strike I am buying (or selling) to determine whether that option is liquid? Or should I be looking at the option’s open interest? Or a combination of the two?
2) Should the bid/ask spread also be taken into account to determine how liquid the option is? Also, typically, how tight should the bid/ask spread be for the option to be considered liquid?
3) If I am interested in entering a spread trade (e.g. 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 have seen strikes with very high options volume but very 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 out the position, that will happen quickly and at a good price?
6) Are there any rules in the exchanges that limit how wide a bid/ask spread can be? For example, if I enter a trade when the bid/ask spread is fairly tight and then, due to lack of liquidity, the spread gets wider, is there a maximum limit to how wide that spread can become? Also, is there a risk of not being able to close out that position due to lack of liquidity?
I never paid much attention to liquidity when trading options on individual stocks, and continue to believe that low volume is not important for most traders. However:
1) Liquidity is important when you believe that you may want to trade those options again, prior to expiration. For example, you may want to close the trade to limit risk, lock in profits, or roll the position to another month. If you plan any of those trades, then liquidity is important from the perspective of efficient trading. It's easier to get your orders filled when the market makers want to trade, rather than avoid trading, the options of a given underlying.
If you avoid trading options with limited volume or open interest, you may (and may not) save yourself some grief. In other words it's a safety play that may avoid trouble later. It's a good idea to avoid trouble.
However, if your plan is to trade these options once and forget about them (not good risk management technique), then liquidity does not matter.
OI on the specific strike is not important. If the OI is decent for the options of this underlying, that should be good enough to encourage you to make the trade. I believe a high OI is more important than high volume but I cannot truly explain just why this is true.
2) Yes bid/ask matters to a point. I cannot tell you how wide the idea bid/ask spread 'should' be – because the bid/ask is not that important by itself. What counts is the TRUE bid/ask, and that is always invisible.
In other words, where do the market makers trade? How far above the bid can you sell? How far below the offer can you buy? That's what matters and you cannot know that without attempting to trade these options and learning the true bid/ask spread (referred to as the 'inside market').
3) No. If one option has good liquidity, it is almost guaranteed that the spread will have good liquidity because the market makers will take the other side of your order. Warning: You must enter the order as a spread and not as two separate orders.
4) Difficult to say. If someone buys 10,000 calls and then the OI remains near 10,000, there is not much liquidity – for your purposes. Sometimes large blocks are crossed by professionals and neither market makers nor individual investors take part in the trade. So if the volume is low, you never really know how easy it will be to make trades at fair prices. The usual case is that high OI and high volume go together, but as you indicate here, that's not always the case. If he market makes want to trade, they will make good markets. If the public doesn't want to trade, there will be low volume.
Because you don't know the mindset of the market makers, you can only discouver the truth by entering orders. When you discover poor quality markets, cross that underlying off your list.
5) You cannot get any such guarantee. If it hits the fan, 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. But, if either OI or Vol is high, you 'should' be okay. But 'should' is not a 100% assurance.
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 exceptions to the rules, and it seems to me that the rules have been ignored for years. To find out the official rules, you can ask that question: firstname.lastname@example.org
The truth is simple: If the market markers become afraid to trade – and that should be very rare – there is nothing you can do. Thus, good OI numbers and good volume should make it easier to trade, but unusual circumstances (flash crash for example) may cause any options to become diffficult to trade.
Keep this in mind: If you are attempting to trade 5-lots, you need not be concerned with any of this.