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Use Bid/Ask Spreads to Measure Liquidity, Not Open Interest

Tony Zhang
March 22, 2018
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Use Bid/Ask Spreads to Measure Liquidity, Not Open Interest

One question we’re often asked about our trades is why we would present ideas that have low volume and open interest. The answer might surprise you: It’s because open interest and volume are not reliable indicators of liquidity. Option liquidity is primarily a function of the underlying stock’s liquidity.

Here’s why:

While it’s true that “liquid” options tend to have high open interest and volume, the opposite is not necessarily true. There are plenty of options with low open interest and volume that are perfectly liquid. So how can you tell? The most reliable means of assessing liquidity is the bid/ask spread of the option.

OptionsPlay uses this to provide you with guidance on where to place your orders. You’ll find yourself pleasantly surprised at how often you’ll get filled near the mid-price for options with low open interest and low volume.

Option liquidity is determined by how easily the option’s market maker can hedge an options trade with the underlying stock. If the stock can be easily borrowed and traded, the specialist generally keeps a narrow gap between the bid and ask price for the options. If you see wide spreads, it reflects the specialist’s reluctance to take risks on a stock with poor liquidity.

Deriving a liquidity indicator from open interest and volume makes sense if you examine the entire options chain of a stock as opposed to just a single option. Believe it or not, the simple reason for this is because most traders prefer to trade round numbers for strikes. It doesn’t mean that less popular strikes have any less liquidity.

To drive this point home, I’ve included the chains for T (TELUS Corporation) . Notice how the 46 and 50 strike price has zero and 40 contracts of open interest, but that doesn’t mean it has any less liquidity than the 48 strike options right next to it with 2,205 contracts of open interest.

The bottom line is, don’t let low open interest stop you from evaluating an option for trading! OptionsPlay methodology for checking liquidity making the assessment simple. Click on “Trade” and OptionsPlay will help you determine how liquid an option is using the size of the bid/ask spread.

Tony Zhang
Tony Zhang http://www.optionsplay.com/

Head of Product Strategy for OptionsPlay

OptionsPlay

Tony Zhang is a specialist in the financial services industry with over a decade of experience spanning product development, research and market strategist roles across equities, foreign exchange and derivatives. As the current Head of Product Strategy for OptionsPlay, Tony leads the research and development of their OptionsPlay Ideas & Portfolio platform. He has leveraged his interest in financial technology and product development to provide innovative, reimagined solutions to clients and the users they seek to serve. Previously he spent 7 years at FOREX.com with a capital markets and research background as a market strategist specializing in equity and FX derivatives markets.

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