Mistake 5: Trading illiquid options

Trading illiquid options

The Option is said to be Illiquid if, the spread between Bid and Ask is high. The Bid – Ask spread is the difference between the price the buyer is ready to pay and the price the seller is asking. The Price is dependent on the stock and also the interest volume. The Volume for big companies is generally high but its too less for the smaller companies.

Stock are relatively more liquid that the Options market. That is because there is one stock but in case of Options for One underlying stock, there may be hundreds of Options to choose for. E.g., if there are 40 Strike price and 20 Expiration period, you have 1600 Various Options contracts to chose from. (40 x 20 = 800 for each CALL and PUT).

So even for companies with huge market cap, the Options may not be as liquid as Stocks. Now consider Options of Mid cap companies whose stocks itself are not very liquid.

Factors determining the Liquidity of the Options

It is very important that you understand the factors that determine the liquidity of Options or the Bid- Ask Spread of Options.

1)    Size of the Company: Large Cap companies are relatively more liquid both in terms of Stocks and Options.

2)    Time to Expiration: Most of the Options traders, trade short term Options (except for Leaps). The longer the time to expiration, the less liquid the Options are. E.g., the volume and interest of the Option for the Stock with same Strike price with expiration 20 days from now will be more than the Option with 80 days to expiration.

3)    Number of notches above or below the Current Stock Price: The closer the Strike price is to the Stock current price, the more will be the volume and interest for the Option with other parameters same. E.g., If the stock is trading at $100, there will be more volume and interest for Options with Strike Price of 95 or 105 than for Options with Strike Price 70 or 140.

What to do to avoid this?

Always check the Bid – Ask spread and make sure that the difference is not high. Sometime the difference may be enough that the Bid price will be below your Stop Loss price and if you follow the Stop Loss religiously, you may require to sell the Option immediately after buying it.