Improved Market Liquidity and How to Identify These Opportunities

Liquidity is a very important factor when trading options as it determines how easy it is to be filled at a competitive price when entering the trade, as well as how easy it is to exit the trade. Volume and open interest tend to be the first things retail traders look at when considering liquidity, but these do not give the full picture as to how liquid a product can actually be. Another misconception retail traders make is that market makers are trading “against them” when taking the other side of the trade. This is not true, and understanding the role and viewpoint of market makers can provide a more in-depth understanding of how liquidity can be found when trading options. To learn more about this topic, please watch our full webinar on Market Liquidity in Canada.

Trader Viewpoint:

Retail traders may have certain assumptions about executing trades, such as:

• “There is another party on the other side of every trade.”
• “If I lose money on a trade, the other side makes money.”
• “Liquidity represents how easy it is to find a party willing to take the opposing trade.”
• “If there is little volume or open interest, I will have a tough time getting in and out of a trade, because no one is willing to take the opposite side of my trade.”

Because of these assumptions, market makers tend to be viewed by many traders in a negative light. However, this is far from the truth. The goal of the market maker is to enter transactions as frequently as possible to potentially overcome the large, fixed costs to remain a market maker. It’s important to understand how market makers turn a profit from taking the other side of your trades. Most trades that are executed are not held as positions but offset with other positions to reduce risk. This allows the market makers to effectively profit from the bid/ask spread while transacting with as many market participants as possible. To attract order flow to trade both sides and make the bid/ask spread into a profit, market makers need to attract order flow by posting competitive bid/ask quotes.

Market Maker Viewpoint:

• “Each transaction is an opportunity to take the bid/ask spread.”
• “The goal is to maximize the number of transactions while minimizing risk.”
• “Once I take the opposite position of an investor, I can hedge my risk against my existing book, or on the open market with shares of the underlying.”

While it is true that market makers are on the other side of the trade initially, this is typically only for a short period of time as their priority is to eliminate the risk afterward. This is done by either offsetting trades against each other (trades that other traders have taken) or hedging the rest with underlying stock (bringing net Delta as close to 0 as possible). Because market makers make money from the bid/ask spread, they aim to maximize the number of transactions and remain neutral as they do not want to carry any directional risk on these positions. There is typically little financial incentive for the market maker whether your trade turns out to be profitable or not.

Single Leg Trade Execution

If a trader buys an Aug $360 Call (53 Delta), the market maker sells the same Aug $360 Call (-53 Delta), effectively taking the other side of the trade. Assuming there were no other trades on that contract for that day for the market maker to offset, the market maker will need to purchase 53 shares of the underlying stock from the open market bringing their net Delta to 0 and is now hedged. This is why options with low volume and open interest can still be liquid as liquidity is contingent upon the ability to buy/sell shares of the underlying and not the option itself.

Spread Trade Execution (Multi Leg)

If a trader opens a spread trade, the market maker only needs to hedge against the net Delta. For example, a trader buys the Aug $360/$380 vertical (53 Delta – 30 Delta = 23 net Delta). The market maker will take the opposite side of the trade by selling the same vertical for a -23 net Delta. From there, the market maker will buy 23 shares bringing their net Delta down to 0. Again, liquidity is contingent upon the ability to buy/sell the underlying shares.

Volume and Open Interest

As stated above, the volume and open interest of an option tell us very little about the actual liquidity of the option contract as market makers can simply buy/sell the underlying shares to execute the trade and hedge their position. However, looking at the open interest of the entire options chain can provide better insight into liquidity. This is because market makers can partially offset their position by buying/selling different strikes to the trader with a different Delta, and simply buy/sell the underlying to offset their risk.

Options Liquidity Research

To understand the metrics behind liquidity, OptionsPlay’s research team explored the bid/ask spread and the effective spread of executions before and after May 2021, when new market makers entered the Montréal Exchange. The effective spread measures the execution price relative to the midpoint, providing a guide on liquidity and execution quality. We saw that after market making competition increased in May 2021, 73% of the top options symbols saw a reduction in effective spreads. The average bid/ask spread was reduced by 15%, providing more competitive quotes, and the average effective spread was reduced by 11.2%.

Furthermore, OptionsPlay research shows that the effective spread on Canadian options was priced at 58% from the mid-price. This single metric can be used to provide insights into where limit orders can be placed to maximize both execution speed and quality. In the example below with a midpoint at $1.00, the average execution limit order placed around $1.10 for purchases and $0.90 for sales would increase the odds of execution at a fair price and speed.

Image: Effective Spread

Source: OptionsPlay

Conclusion

Liquidity is a constant concern for traders who naturally want to be able to execute their trade at a competitive price and speed. However, many traders lack the data to measure liquidity. By looking through the lens of a market maker, it provides a clearer picture of the option’s liquidity and how it is contingent upon the ease at which market makers can buy/sell the underlying asset to hedge their risk. It is also important to remember that an option’s open interest and volume do not provide the full picture of how liquid it is. It is better to focus on the entire options chain to better gauge the liquidity of an option.

Take advantage of free access to OptionsPlay Canada: www.optionsplay.com/tmx

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

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