This post was originally written on February 4, 2013 at http://www.optiontiger.com/option-liquidity/
In the Options world, you can measure Options Liquidity using several parameters. The more liquid an Option is, the better your chances of profits because you want to minimize "slippage" in the trade. These are the different ways to judge liquidity.
1) Bid Ask spread
When you enter a trade, you're always entering at a disadvantage because of the Bid-ask spread. Of course, we can't get away from the Bid-Ask spread, because this is one of the ways the Market Maker makes money. So what is a decent Bid-Ask spread ? You have to look at the ratio of the Bid-Ask spread itself as a percentage of the Bid price. The calculation is (The Bid ask spread) / Bid price. Let's say an Option Bid-Ask prices are 10.00 and 10.50.
- Then the calculation is (10.50 - 10) / 10 = 0.5 / 10 which is 5%.
- You have to bear in mind this is your loss at entry. Any gains you make must overcome this disadvantage.
- As a guideline, 5% is quite high, anything around 2 to 3% is acceptable.
- Less than that is desirable. You'll see 1% or less in highly liquid stocks and ETFs like the SPY and even AAPL.
- Anything over 5%, you're putting yourself at a serious disadvantage
2) Volume and Open Interest
Volume is calculated on a daily basis, and Open Interest is the cumulative running total of all Options contracts that are still "open". When you open an Options position, you must close it at some point because Open Interest must drop to 0 on the day of expiry. So you don't want to get stuck with an Option that does not have good liquidity. You won't be happy with the fill the market maker gives you. As a rule of thumb, an Open Interest of 1000 or more on any Option contract is acceptable. As far as Volume is concerned, you may find that Volume in a particular Option contract does not pick up for an hour or so after trading starts for the day. If this is the case, then you should wait until volumes starts coming in. If you try to get your order in earlier, you may face slippage on the Bid-Ask spread.
- More demand = Tighter Bid-Ask spread
3) Options strike width
You will notice that if Options on a stock are very liquid, the width of the strikes get closer. This is because when there is demand, Market makers will try to provide additional Strike prices to get more traders into positions. You'll very often see that in between a $5 strike width, they'll squeeze in another strike - example, 55, 57.5, and 60. After 60, it may go to 65.
- Closer strikes = more flexibility for the trader
4) Number of months of Options contracts
You'll often see that many stocks may have the next month contracts, and then it jumps to 3 months down the line. This creates problems if your strategies involve Time spreads - Calendars or Diagonals. Lack of continuity in monthly contracts makes it less flexible for you as a trader when you have to make adjustments to your time spreads like rolling your position. Let's be clear - all stocks will see a break in monthly series. Even a highly liquid stock like AAPL will see a break 3 months down the road. But if you have at least 2 or 3 continuous monthly series, you're in good shape. Also look for Weekly, and Quarterly series - these provide increased liquidity and flexibility.
You may not find very many stocks that satisfy all of these parameters. But if it satisfies at least 3 out of 4, this should be good enough. The important ones are the Bid-Ask spread and Volume / OI. These two parameters can impact your position in a big way.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.