Liquidity is vital when placing options deals. This article examines the importance of trading the most liquid options.
I’m going to share some tips to make sure you are trading the most liquid options.
Since lower liquidity equates to higher transaction costs, it is important to always consider these costs and how they add up over time.
Liquidity in the options space is generally defined as the price we pay to enter and exit a position.
Even if you are with one Commission-free brokerage, Trades are not free.
As private investors, we are mostly liquidity takers.
That is, we place trades in interaction with a market maker who is a liquidity provider.
While there are several ways to measure liquidity, one easy way is this Bid / ask spread, As shown below.
The bid price (shown in green) is the highest price someone is willing to pay to buy the option.
The ask price (shown in red) is the lowest price someone would want to get to sell that option.
The difference between the bid-ask price is known as the spread.
The larger the spread, the higher the transaction costs and thus the liquidity.
Let’s look at the strike shown in yellow.
We have a bid of $ 4.10 and a bid of $ 4.30 for a spread of 20 cents.
So if we were to buy and sell the option right away, we would pay 20 cents at most. Often times the real costs are even lower.
This is because liquidity is often hidden in the bid-ask spread.
As we can see from the AAPL options chain, the options are very liquid. Below is an example of an illiquid options chain.
Here are the options for Unifirst, a workplace uniforms company.
As a $ 4 billion company, we can find that the options have no volume and virtually no liquidity.
If we look at the bid-ask bill for the 260 calls, we can see that the spread is a staggering $ 8.50.
These are the options we want to avoid.
If we want to continue trading the underlying asset and have a directional view, it is better to buy the stock.
The most important thing a trader needs to have is a positive expected value for the trades he is making.
Without it, we just sit at a roulette table and bet on red.
Even so, there is no way to take advantage of positive expected value without liquidity.
Because the less liquidity there is, the more of our advantage the transaction costs are devoured.
Liquidity is always there when you want it, but never when you need it.
Sometimes stocks appear liquid and have a tight bid to ask about spreads.
But in times of Market crises This liquidity begins to evaporate.
The markets move quickly and the bid-ask spread increases significantly.
Most of the time, we need the liquidity most at exactly the same time. Because others are forced to drop out of a position.
By focusing on the most liquid options, we reduce the risk of our liquidity being taken away when we need it most.
These semi-liquid options can be traded but must be treated with caution.
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Another important key figure for determining liquidity is the depth of the market. Imagine the bid-ask only has one contract on both sides, but I have to sell 100 contracts.
For most retailers with smaller investments (myself included), depth of market is not a major concern.
But when you start managing millions it becomes much more important.
Often times, if you listen to a podcast from a fund manager who manages billions of assets, they will spend half the time talking about liquidity.
This is due to the size of their orders and positions.
For them, the importance of market depth and liquidity cannot be emphasized enough.
So how do you go about finding the most liquid options? Here are 5 tips that I use.
Focus on tickers with a high average option volume.
This means, rain or shine, many options are traded in the ticker.
I would immediately filter out any stocks with fewer than 10,000 daily contracts traded.
Look at the option strikes that have a higher open interest.
Certain strikes are more popular because they are close to the money or have round numbers.
Think Tesla 990 calls versus Tesla 1000 calls.
These strikes often have greater liquidity and a tighter bid-ask spread.
Monthly magazines have more liquidity than weekly newspapers.
When weekly contracts are available, the monthly magazines usually have more liquidity.
The monthly journals are the options that expire on the 3rd Friday of each month.
Consider executing trades around noon.
Options market makers compete against each other to keep the bid-ask price as tight as possible.
When the market first opens, prices are more volatile and spreads widen.
However, because volatility sets in after open spreads often tighten, market makers aren’t as concerned about being caught up in price jumps.
Find hidden liquidity for yourself.
Place a limit order a little below the ask and see if you can find any hidden liquidity.
If not, postpone the order for a few cents or leave it and see if someone picks you up.
By simply using these five tips, you can make sure you are not paying high transaction costs and ensure that you are trading in a liquid underlying asset.
If we are not satisfied with the liquidity of the options, we can trade the underlying asset.
Buying the stock itself is becoming more liquid and should be considered when we have a directional view.
Below is a list of the most liquid options for individual stocks.
Some of these names may come as a bit of a surprise, but this data is from March 2021, right at the time of the Gamestop / Short Squeeze Craziness.
It’s pretty funny names like NOK
TICKER DESCRIPTION 90 DAY AVERAGE VOLUME
AAPL Apple 1,725,465
TSLA Tesla 1,030,548
PLTR Palantir Technologies 811,116
AMC Amc Entertainment Holdings 737,906
GME Gamestop 699.634
NIO Nio ADR shares 610,975
ADR shares sponsored by NOK Nokia 573,376
F Ford Motor Company 490.429
FB Facebook 368.071
AAL American Airlines Group 298,826
GE General Electric Company 279,987
CCL Carnival 227,459
BA Boeing Company 207,066
XOM Exxon Mobil 193,213
DKNG Draftkings 171,688
RKT Rocket Companies Class A 125,836
Here is a list of the most liquid options on ETFs.
No big surprises here, and this list stays pretty consistent over time.
TICKER DESCRIPTION 90 DAY AVERAGE VOLUME
SPY SPDR S & P 500 ETF Trust 4,294,738
QQQ Invesco QQQ Trust 1,111,653
IWM iShares Russell 2000 ETF 747,211
SLV iShares Silver Trust 701.434
VXX iPath S & P 500 Vix Short Term Futures ETN 387,695
EEM iShares MSCI Emerging Markets ETF 357,640
HYG iShares iBoxx $ High Yield Corporate Bond ETF 299,918
UVXY Ultra Vix Short-Term Futures ETF 298,826
XLF Financial Select Sector SPDR Fund 276,693
XLE Energy Select Sector SPDR Fund 273,607
GLD SPDR Gold Shares 182,729
SQQQ ProShares Ultrapro Short QQQ 160.606
EWZ iShares MSCI Brazil ETF 157.744
GDX VanEck Vectors Gold Miners ETF 136,576
TLT iShares 20+ Year Treasury Bond ETF 121,958
FXI iShares China Large-Cap ETF 78,360
Liquidity is the cost of doing business in the options space.
When placing trades, it is always important to focus on the liquidity of the underlying asset.
By trading the most liquid options, we guarantee that we are paying the lowest transaction costs.
Additionally, we are more confident that liquidity, when we need it, will be there for us in the event of market turmoil.
Ultimately, we have more of our advantage and money in our pockets.
Disclaimer: The information above applies to For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.