In Options Trading What is the Best Way to Assess Liquidity?

In the late 1990s and early 2000s, I co-founded one of the world’s largest options education companies with several partners, including George Fontanils. We took our company global.

We were doing options education ‘live event’ seminars all over the U.S. and Canada. We even held these sessions in the UK, Singapore, and Australia.

It was a very wonderful time to be able to meet people the world dover and see that they all shared a common interest and that was to better their financial situation through the skill set of learning to trade options. It was very humbling to be able to serve in that capacity and even though I educate on a smaller scale it is still a calling, if you will, I still am grateful to be able to serve.

Many students had a question regarding options trading, and it was even just recently asked in one of my online sessions. What is the best indicator of liquidity for options.

Options Liquidity

What the question pertains to with Options liquidity is how easy can traders buy or sell options contracts without significantly impacting the contract’s market price.

Here are the three primary means to assess options liquidity.

Daily Volume – This is the number of times a specific option contract was traded in a day. A Higher daily volume indicates better liquidity.

Open Interest – This is the total number of outstanding option contracts that have not been closed or exercised. A higher open interest suggests greater liquidity.

Bid-Ask Spread – A narrow bid-ask spread indicates a liquid market, while a wider spread suggests lower liquidity

What I and my colleagues taught is the BEST indication of liquidity is this last one, a tight Bid-Ask Spread.

Think about it options are priced with a bid and an ask and the difference between the two is called the spread. I want to cover the spread and then some as quickly as possible and with the least move possible required in the security.

If you have an option that is priced $2.20 x $3.00, that means the option has to move +$0.80 just to be break even. Where as an option priced at $2.00 x $2.03 only needs to increase by $0.03 to break even.

Options ‘Slippage’

I also like to trade options with the lowest percentage slippage possible.

Options slippage is defined as the difference between the expected price of a trade and the actual price at which the trade is executed/filled.

The formula for slippage is:

Slippage = Execution Price − Expected Price
__________________________________________   x 100
Expected Price

I like options with a 1% or less slippage. The lower the better giving me a better chance at getting profitable quicker.

Check with your broker if their options trading platform provides a slippage calculation on options like my tools / software at www.tomsoptiontool.com does.

The Reason for Finding the Best Liquidity

Knowing an options liquidity is especially important to me and why I teach it is because liquidity in options trading affects a trader’s ability to execute transactions efficiently and at favorable prices.

Higher and better liquidity makes for ease of Entry and Exit.

In a liquid market, traders can buy or sell options contracts without causing too much of a price fluctuation. This in turn pretty much ensures trades can be executed close to fair market value.

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You must be aware of the risks and be willing to accept them in order to invest in the stock and options market. Do not trade with money you cannot afford to lose.

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