If you truly want to make more money trading options, you need to start thinking about the options you trade now. Liquidity should be combined with other metrics as you perform your market research, but some traders overlook its advantages.
In this post, I wanted to share some of the reasons why an option liquidity should be a top priority as you scan for new trades.
- Volume = higher liquidity - Typically, the more options volume there is a for contract, the more liquidity will exist. These contracts are then much easier to move in and out of. This can be important if you need to move in and out of your position quickly.
- Buy and hold is a fallacy - Old school investors buy “good quality” securities, and then hold them. Not so with options trading. When you see an opening to secure a nice profit – you want to be able to take it. Ensure that options liquidity is high before you execute your order.
- Allow for adjustments - If it is difficult to open a contract because of low trading volume, chances are, it will be equally difficult to close a contract out. This can make fine tuning your investment strategy challenging.
- Options interest as a sign of liquidity - As you enter into an options position, the transaction is an opening, or closing one. Buying ten calls, for instance, is an opening transaction. When you sell your position, you are typically closing the transaction. High open interest signals high liquidity.
- Wider bid/ask spread signals more risk - The wider the spread, the larger the price move in the contract is needed to realize a profit or loss. Since the spread is wide, it means that the exchanges have to make up the low liquidity with wider profit margins.
- Determine your risk tolerance - Implied volatility can be a good metric in determining risk exposure. The higher the volatility, the higher potential for big moves – up or down. High liquidity tends to equal lower implied volatility.
- Buying with an eye towards selling - When it comes time to pull the trigger on your contract, you don’t want to be left holding the bag. Execute a contract that can be cashed in later even in a slow moving market.
- Understand how liquidity impacts the bid/ask spread - Very similar to #5 above. Higher options liquidity means higher trading volume, and thus, less variance when it comes to pairing up buyers and sellers.
- The growth/scalability of your portfolio in the future - If you find a strategy that works and start consistently making money, your portfolio will grow. This creates a new set of challenges. It's easy to invest $100 anywhere in the market, but $100K is a little harder to invest when trading. Focus on options that are scalable.
- Margin fluctuations - Your margin balance can swing wildly during the month, but what do you do if you need to reduce/sell some exposure? Typically you won't have that much time to meet a margin call so being able to get out of options quickly can save you forced exits by the brokers at extremely unattractive prices.