Liquidity is how easily an investor can buy or sell an asset without losing much value. The more an asset is traded, the more liquid it becomes.
At tastytrade, we only trade liquid products because as self directed investors, we want to trade the most efficient option markets. In addition, this allows us to get in and out of our trades at a fair price. As long as we stick to the most liquid products, we know we will give up little edge getting in and out of our trades.
Now that we understand the meaning of liquidity, it is important to understand the criteria we look for at order entry in order to decide whether a product is suitable to trade. It is important to assess stock and option volume before placing a trade. Because options are a derivative of stocks, if the stock has low volume, so will the options. In addition, the bid/ask spread will tell us how tight the markets are, and represent the prices we know we can get in and out of our trades at. Another important reason we trade products with extremely liquid options is because more liquid options have much more accurate probabilities (as calculated by the Black-Scholes pricing model).
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