Professional Options Traders use numerous methods to evaluate the worthiness of a prospective trade. A laundry list of tools is evaluated in anticipation of establishing a trade which will provide an excellent rate of return on investment. The list of factors to review might include: fundamental analysis, charting, Implied and Historical Volatility and a multitude of other Option Valuation techniques. All of those factors are important however, if one is trading options in an illiquid market, the likelihood of making money in the long-run is greatly diminished.
As a former market-maker on the floor of various exchanges, I am acutely aware of how significant a portion of profit or loss can be attached to the simple analysis of the bid/ask spread. The bid/ask spread, is also known as liquidity, edge or vig. When markets are liquid, the costs of implementing positions enable traders to establish positions without significant cost. Whether you are Selling Options for Income or establishing more complicated positions, without liquid markets, the long term success of the trader is compromised.
Whenever you are establishing a position you should calculate the cost of initiating the position as a percentage of the underlying options they are trading. For example, if a Call has a Bid of 1.00 and an offer of 1.01 then it would have a market that was 1% wide. This is a way of measuring liquidity. The Table below shows the liquidity percentage for numerous options contracts for Stocks and ETFs with May expiration. The wider the spread, the more difficult it is to make money. For example, if an option has a Bid of 1.00 and an offer of 1.15 then it has a 15% spread. Depending on the Delta (the movement of the Option Value compared to the movement of the underlying contract) of the Options, you have to have a significant move in your favor to make money. If you Buy the Option on the Offer at 1.15 and are going to Sell it on the Bid in order to liquidate, then in order to make a profit on a .50 Delta Option the underlying would have to move in your favor more than 30 Cents. Establishing a position in this environment, where you are constantly giving up such an edge, will prove disastrous.
As you can see from the Chart below, it is relatively simple to calculate the liquidity percentage, but it is an essential part of the analysis for any trader. In addition, liquidity should only be evaluated for the out-of-the money portion of the Option. If one uses the in-the-money portion, it places too much value on the portion of the option that relates to the underlying contract instead of focusing on the bid/ask spread of the “time value” portion of the option. Also, keep in mind the Delta of the Option that you are trading. The smaller the Delta, the more difficult it is to compensate for the liquidity costs. The Option only moves at the Delta’s percentage of the underlying. Therefore, an Option with a Delta of .25 will only gain 25 cents for every one dollar move in the underlying. Whenever analyzing an Options Trade evaluating Liquidity Costs should move to the top of your list. Instead of establishing positions in illiquid options, you can look for trading proxies by using other instruments that provide a high correlation to the underlying contract you intended to trade, but with significantly greater liquidity.
Examining the fundamentals, charts and a multitude of Options Greeks and Trading Strategies is a necessary requirement for all Options Traders, but without the liquidity test, your success as an Options Trader will be short lived. Options Markets are unforgiving, but with the aforementioned due diligence, profitable trades are more likely.
OPTIONS TRADING INVOLVES SIGNIFICANT RISK AND IS NOT SUITABLE FOR EVERY INVESTOR. THE INFORMATION IS OBTAINED FROM SOURCES BELIEVED TO BE RELIABLE, BUT IS IN NO WAY GUARANTEED. PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS.
