I’ve read a few option books.
THANKS... This is probably the most comprehensive "greeks" article/book I’ve read.

Wonderful blog. …..
A wonder wealth of knowledge there. Thanks so much for your kindness in publishing it!

Thank you very much for the most concise and simplest option intro. Highly recommended.

So far, yours is the best blog/site on basic options notes in the web that I have chanced upon.

Monday, August 6, 2007

How To Determine Options Liquidity?

Quite often I read articles which tell us that options liquidity can be measured by open interest. Because when options have high open interest, this means there are more people interested in the trade, and as a result, it’s more likely for us to get a better pricing for the trade.

Yes, this is quite true. Normally, the higher the open interest, the more likely we’ll be to trade that option at a narrower spread between bid & ask prices. On the other hand, the lower the open interest, usually there will be a wide spread between bid & ask prices.

However, in many occasions, I found that options with high open interest still have a wide bid-ask spread, i.e. about $0.3 or more.
On the other hand, sometimes options with low open interest might have a narrow bid-ask spread too. When I traded such options, the fillings were also quite fast.
Therefore, to me, open interest is not really the important criteria to decide whether I should trade the option or not. It’s the spread between bid & ask prices that matters more to me.

Generally, the maximum bid & ask spread I’m willing to accept is $0.20 for ITM options, $0.15 for ATM, and $0.10 for OTM options.
So, although the open interest is high, but if the bid-ask spread is too high, I’ll normally pass that trade. On the contrary, even though the open interest is low, but the bid-ask spread is still acceptable, I may still trade that options.
But of course, ideally I like to trade options with high open interest and narrow bid-ask spread.

Why getting a narrow spread between bid & ask prices is important?
Because this can affect your profitability significantly. Also, it’s important to consider how much the stock price is expected to move versus the bid-ask price spread of the options.

For instance:
You expect a stock to increase by $1 within a very short term. If you buy an ATM Call option (delta is 0.5) and the bid-ask spread is $0.4. That means, just to break even, the stock price will need to increase approximately by $0.80 (=$0.4 / 0.5). Should the stock price moves as expected and rises by $1, you’ll only profit about $0.1 [=($1 x 0.5) – 0.4]. If the stock only increases, say, by $0.6, you will still lose money.

On the other hand, if the bid-ask spread is only $0.1, you only need the stock price to move up by about $0.20 (=$0.1 / 0.5) before you can start to profit. If the stock price does rise by $1, you would gain about $0.4 [=($1 x 0.5) – 0.1].

Related Posts:
* A Chance to Learn from World Class Trading Experts For FREE You Should Not Miss
* Option Chain
* Difference Between Option’s Volume and Open Interest


OptionPundit said...

Good thought OTB, sometimes we need to look at the absolute price of the stock or option as well and see bid/ask spread as % of that. You may find that it's fine to trade even for a higher spread vs narrow (in absolute terms) like SPX vs SPY and RUT vs IWM.

Cheers and keep up the good work, OP


Hi OP,

Good point! Thanks for the valuable input.
Yes, you're right. To make it more generalized, it's good to use % than absolute dollar. Because if the stock/options price is high in absolute dollar, the bid/ask spread will be higher too.

What I mentioned in the post is my own personal rules, as I usually trade options of stocks with price less than $100, hence the options' price is not too high.

Hence, the rules should be adjusted according to one's trading style / criteria.

Thanks again.


Tony Chai said...

Hi OTB :

This reminds me of a recent trade on RRGB (Red Robin Gourmet Burgers) which reported earnings on 16/8/07.

Although RRGB gapped up +$2.50 to $39.00 on 17/8/07, the Sep 40 Call still lost money because the bid/ask spread of the thinly traded option was more than $0.50.

Yours Truly,

Tony Chai

Oskar said...

Hello Tony,

I think you have to consider other factor if you want to play an earning play. You have to realize that the IV pre-earning is considerably higher than the IV post-earning (IV implosions).

This is why I rarely play earnings with straight buy call or buy put.