The Importance of Liquidity
The term liquidity refers to how fast something can be entered or exited and turned into cold, hard cash (the kind you stick in your wallet). Highly liquid underlying stocks allow you to enter or exit the market more quickly and at better pricing with narrow bid/ask spread. In this video, I want to show you a real example of a trade I could not exit to save my life no matter what price I tried. Nobody was on the other end to take this trade and I learned a hard lesson about liquidity.
In this video, I want to talk again just about the importance of having liquid options that are tradable for your portfolio and for your system that you're creating in your trading plan.
I learned this lesson the hard way in December of 2014 because I had made a trade in A&F which is Abercrombie & Fitch and we were trading this stock around earnings.
We made a nice iron condor trade on A&F, and everything was going good, and as we got closer to expiration, I wanted to close the position, but what I found was that the liquidity or lack thereof of liquidity in the market was so low that no matter what price I put in.
I could not get filled. I want to go through some of those orders here today just to show you how many orders we tried to place. In fact, I even tried to overpay for getting out of the trade, deliberately putting myself in a bad situation just to see if the market would fill that order.
And because there was just nobody on the other side of the trade, it was a trade that I had to let go all the way to expiration, and thankfully it was a profitable trade.
But it could've gone completely against me, and I would not have been able to get out of the trade. It proves the point of having high liquidity and very active securities that you need to be trading in your portfolio.
On the screen here is my Thinkorswim platform and I went back 300 days from that date just looking at all the different trades that we made in A&F. You can see as I scroll down here that our only fill and order history was the actual entry of the trade.
You can see that opening trade to close and this is going back 300 days. This encompasses everything. I’m not hiding anything and trying to say that I didn’t get filled. No. I only got filled on just the opening orders to get into this security, and that was on 11/7.
That’s when we got filled on the security which is 11/7. What you can also see is that we tried to get out of this trade on 12/4, 12/3, 12/4 again, 12/3, 12/3, 12/3. On a couple of days, we were trying to get out of this trade; we just could not possibly exit the trade.
You can see because, on the right-hand side of the screen here, you can see that these orders expired or were canceled and replaced by other orders because they just wouldn't fill.
In fact, at some point during the day, we actually entered a trade to get out at an $.8 debit and when the market was trading around $.6 or $.5 to close out the position, you can see a lot of the prices that we’re going for is about $.6, $.5, $.4 at one point, we tried.
But at one point during the day, we tried to get out of the trade just saying, “Hey, we’re going to overpay to get out of this security, hoping that somebody would come in and release us from the trade and bank our profit.” But even, in fact, trying to overpay for the market with just nobody there, didn't end up closing out the trade.
This just really goes to show you that if you want to create a very profitable business around trading and making high probability trades, a requirement of doing that has to be liquid options because you can get into a great trade like we did in Abercrombie & Fitch, in A&F.
We got into a great trade, it ended up being a profitable trade, but had we need to make an adjustment or close a position, we just could not close the position because nobody was there. This proves the point, and hopefully, you know now that you have to stick to high probability trades.
We do publish our watch list of prescreened and pre-scrubbed securities that have highly liquid tradable options, and you can get that from optionalpha.com inside the membership area. If you guys have any questions on liquidity, please post them right below.
If you want me to check out a stock that you don't know, if it has good enough liquidity, put the ticker symbol in the comments below this video and I’d be happy to take a look at that stock and let you know my thoughts on if it needs the liquidity requirements that we have.
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