You won’t be able to swim in a pool without water and you won’t be able to get filled at a decent price on a trade when there’s not many buyers and sellers in the market. What do these two things have in common you may ask. Well, both relate to liquidity.
If you want to jump into a swimming pool, it obviously needs to be filled with water and it needs to be liquid. This applies to trading too. If you want to jump into the market and place a trade, there needs to be buyers and sellers in the market. Ideally, there needs to be a lot of buyers and sellers. The more traders buying and selling the stock or option you’re trying to trade, the better the price you’ll be able to get filled at on the trade. This means you can get in and out of trades easily at a favorable price.
What determines how liquid an option is? Check out our second tastytrade & dough concept video below.
When determining if an option is liquid, we primarily look at three things, the bid-ask spread, volume, and open interest. The most important of these being the bid-ask spread, since the spread will normally reflect the level of volume and open interest.
The bid-ask spread is the difference between the price someone is willing to buy the option for (the bid) and the price that someone is willing to sell an option for (the ask). We look for bid-ask spreads that are $0.10 or less, but ideally, the tighter (lower) the spread the better. The tighter the spread between bid and ask prices, the more likely it is that a trade is filled at the mid-price between the bid and the ask.
High volume is important because it means that the option is frequently traded. The more something is traded, the more buyers and sellers there are. This results in a tighter bid-ask spread. Ideally, we look for stocks where over two million shares have traded and options where thousands of contracts have traded.
Also, open interest needs to taken into consideration when determining liquidity. Open interest is the number of option contracts that are currently in existence (haven’t been closed out). An option that has over 500 contracts in open interest is ideal. This indicates a high level of market participation, meaning the bid-ask spread should continue to remain tight.
Regardless of your trading style or the products that you trade. Liquidity is a key concept to understand. The more something is traded the more liquid it is and the easier it will be to get in and out at a price that you like. This is important because just like it would hurt to jump into a pool without water, it hurts to get stuck in a trade you can’t get out of at a good price.
Make sure to check out the first video in this series to learn more about why we choose to sell options premium.
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