Trading and Liquidity

Hi Mark,

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?

Thanks

DC

***

Hello DC,

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: options@theocc.com

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.

818


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8 Responses to Trading and Liquidity

  1. Roberto 10/25/2010 at 4:58 AM #

    Hi Mark
    during your conference on oct 12, you said that the only way to adjust a losing side of an IC is:
    – buy an option
    – buy a spread
    ANd then you said that there are other alternatives, but that wasn’t the good time to talk… can you explain us the “other alternatives” to adjust a losing side of an IC?
    Did you mean adjust using otm calendar spread? Or with an otm butterfly?
    Thanks in advance
    Rob from Italy

  2. Mark Wolfinger 10/25/2010 at 8:28 AM #

    Roberto,
    Those were two alternatives. I also suggested covering shorts and selling a larger quantity of farther OTM options – if your risk remains under control.
    I never suggested these were the ‘only’ possibilities.
    Yes, an OTM calendar spread is one choice. It’s an often used method. It allows for limited profits and does nothing to help when the big move comes. This play requires constant monitoring.
    Any play that a) brings delta closer to neutral; reduces negative gamma; earns a profit when the market move continues – each of these is an acceptable adjustment. Yes, that includes OTM butterflies. The list is pretty long – it just requires using imagination: For example, backspreads or diagonal backspreads can be helpful.
    Rather than concentrating on a list of possible trades, I believe it’s best to concentrate on the goal: reducing risk. Many times a simple exit is best and most effective. Not all positions can be salvaged.
    thanks

  3. jeff partlow 10/25/2010 at 8:35 AM #

    Mark,
    You advocate active position management, and I agree with you on that. But high bid/ask spreads (which usually go hand-in-hand with low open interest) can significantly degrade trading profits (look into substantial academic research confirming this), and should (as DC implies with his very good and thoughtful questions) be a consideration when analyzing a potential investment. My personal preference is for options with open interest at a minimum of greater than 300, and preferably greater than 1,000.

  4. Mark Wolfinger 10/25/2010 at 9:08 AM #

    Hi Jeff,
    The more actively one trades, the more important liquidity becomes. But, I do not disagree with your statement that low liquidity and wide spreads detract from profits.
    If I want to trade a specific stock – for a good reason – I would take a chance with wide markets – once. If, for example, the spread is bid $2.20 and offered @ $3.20, that’s a horrible market. But if I have no trouble selling at $2.65, or 5 cents under the midpoint, I’d still be willing to enter my order.
    As far as OI is concerned, I often open positions in options with ZERO open interest becasue I trade these options on the first day they are listed for trading.
    That may not be for everyone. Jeff, I appreciate your comment – it is a good warning to traders. I have a difficult time drawing the line between describing what I do and what I recommend for rookies. These do not always overlap.
    Regards

  5. Roberto 10/25/2010 at 9:23 AM #

    First of all, thanks for sharing
    We agreed that not all positions can be positively adjusted, I was only tryin to make some sort of “list” of possible adjusting of an IC losing side, with pros and cons, than test it and see which one is better under some circumstances like x IV, x otm, and so on…
    I know that trading (and adjusting) it’s an art, but I’m triyn to define some adjusting rules.
    Again, thanks
    Rob

  6. Mark Wolfinger 10/25/2010 at 9:41 AM #

    Rob,
    It’s all a comfort zone/personal preference strategy, but I prefer:
    The first decision for you is: When to adjust. At what point do I want to make a small adjustment to get a better position. I call this adjusting in stages. Some people prefer to wait until it’s time to make a big adjustment. Neither is right, but I like one small adjustment, then another – as needed. Until it’s a mandatory exit.
    1) Buying net options, if the price is acceptable. There is nothing like a naked long option to ease the pain of a large move.
    But in my opinion, it must be less far OTM than your short options.
    2) But those are costly and I believe well struck (again, less far OTM) credit spreads offer decent protection at a very reasonable cost. Obviously, if these are bought when essentially ATM, they are not cheap.
    3) Rolling the position often works. You move the current trade to one you like better. However, ‘rolling’ can become a bad habit.
    Some people roll as a method to ‘do something’ and I strongly recommend rolling ONLY when you want to exit AND like the new trade. It’s tempting to roll in an attempt to salvage a trade and end up owning a bad position. Try to avoid that.
    4) OTM calendars are excellent. However, when the underlying moves near that strike, this position is now a liability – on a further move. Whether to hold that calendar is a tricky situation. I prefer to exit. Why? I already do well when time passes and there is no need to own a 2nd trade that loses on a move and wins on decay.
    5) At OTM butterfly is a good idea. It profits where you need protection. However, same problem. If the move is too far, the fly loses money.
    6) You can also buy/sell shares of the underlying (using a DITM call option if it’s an index) to adjust delta. This is a very popular choice. But, I don’t like it because it gains no gamma. Personally, I like to reduce negative gamma. You may not feel as strongly. That’s why there are personal choices.
    I know I am repeating myself, but the game is less risk, and that means less gamma and less delta. It also means being certain not to grow vega risk to unacceptable levels.
    We can discuss something specific if you care to do so.
    Regards

  7. Dimitris 10/25/2010 at 2:50 PM #

    Mark,
    You said in your answer to Roberto (point 6) that buying/selling shares of the underlying is a popular way of adjusting.
    If, instead of buying stocks, we buy a call and sell a put (same strike price) as something equivalent, what are the advantages and disadvantages of such an action?
    Thank you

  8. Mark Wolfinger 10/25/2010 at 4:31 PM #

    Dimitris,
    Yes, you can buy one call and sell one of the corresponding put to gain 100 shares of the underlying, or 100 delta.
    There are ZERO advantages/disadvantages. This is exactly equivalent to buying 100 shares of stock. However, there may be a reduced margin requirement for one play vs the other, so I would check the margin requirement for the adjusted position prior to making the the trade, if possible.