Using Liquidity to Your Advantage
Dec 7, 2017
By: Sage Anderson
One of the core tenets of the tastytrade approach is to seek out liquidity when trading volatility.
A high level of liquidity typically provides investors and traders with several tangible advantages over lower liquidity securities.
On a high level, this same methodology can also be applied to other segments of the investment universe. For example, investors are likely to feel a lot more comfortable purchasing a home in an area with a greater number of residents, versus a region with a sparse population.
It's a lot easier to sell a home when there are are people looking, and more average transactions per year.
The same principles can be applied to the options universe. And there are several other important advantages to trading high volume options, as well.
If you are looking for more information on this topic, a recent installment of Best Practices is a great place to start.
On the show, the hosts highlight some of the most important liquidity filters that traders can use when selecting the appropriate underlying, including:
High volume (across strikes)
High open interest (across strikes)
A tight bid-ask spread
Multiple expiration cycles
While each of the bullet points above is important in its own right, it's the sum of them that typically creates the biggest advantage to trading highly liquid securities - the compression of the bid-ask spread.
The bid-ask spread is, of course, the difference between the price one pays to purchase an option (at the offer price) versus selling an option (at the bid price). For example, if the bid for a given option is $0.50, while the ask is $0.80, the bid-ask spread is equal to $0.30.
If we assume the midpoint of the bid-ask represents fair value, then the fair market value of this sample option is $0.65.
That means a trader paying $0.80 to purchase the option has already paid $0.15 over fair value to enter the trade - putting the position at an instant disadvantage. The same could be said for a trader selling the option at $0.50.
In general, highly liquid options have tighter bid-ask spreads, which means traders give up less edge when entering the position. The graphic below illustrates how tighter bid-ask spreads provide traders with a clear advantage at trade deployment:
As you can see in the slide above, the bid-ask spread of the option on the right allows traders to enter the position without buying/selling significantly above/below fair value.
You can also imagine how a narrow bid-ask spread is likewise advantageous when trading out of a position.
This installment of Best Practices includes an introduction to tastytrade's own liquidity rankings, and how traders can use them help filter for attractive opportunities, and to avoid potential pitfalls.
A summary of the tastytrade liquidity rankings is shown below:
For more details on options liquidity, as well as practical context from Tom and Tony, we hope you’ll take the time to review the complete episode of Best Practices when your schedule allows.
If you have any questions about identifying and selecting the appropriate symbols/products for your portfolio relating to liquidity, we also hope you’ll leave a message in the space below, or reach out directly at email@example.com.
Thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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