Let’s face it: investing is a bit of a popularity contest. Just as fashions come and go, investors tend to favor certain stocks, bonds, or futures contracts. And preferences change over time, all the time. The result is a larger pool of buyers and sellers for some tickers, while others sit idle with little to no trading activity.
In the more active markets, the increased participation makes it easier to take new positions or exit existing ones without affecting prices too much. In market lingo, such investments have liquidity. Anything that can be easily bought and sold is known as a “liquid” asset. All else being equal, the more liquidity, the better.
How Do We Measure Liquidity?
In the options world, liquidity can vary a lot from one instrument to the next. In fact, there is real inequality today. According to a recent study by Henry Schwartz at Trade Alert, the top 132 most active names, or 3% of listed options, see roughly 80% of total trading volume. In other words, the bottom 97% see only 20% of the options volume. Clearly, the deeper liquidity pools are concentrated in a handful of names in the options market these days.
Two important indicators can help you size up liquidity: daily volume and open interest. While volume in equities is measured by shares, the volume for an option is based on the number of contracts traded. If, for instance, one name sees average daily volume approaching 1 million contracts, it is among the more liquid. On the other hand, a ticker that sees daily volume of just a few hundred contracts is not seeing much action and might not have ideal liquidity.
Open interest measures the number of contracts that have been opened and not yet closed. The Options Clearing Corporation (OCC) updates the volume and open interest numbers daily for all listed options contracts and you can access that data on the TD Ameritrade thinkorswim® platform. Taken together, volume and open interest can give a sense of whether an option contract is very liquid, sort of liquid, or gathering dust (see figure 1).
Why Is Liquidity Important?
A fragmented options market spread over 12 exchanges can sometimes pose execution challenges for institutional investors (let’s say hedge funds) and their block-trade transactions, which may have to spread over more than one exchange. But it’s not typically a problem for individual investors. That’s because smaller orders are simply routed to exchanges to get the best prices possible.
Yet, more liquid and actively traded options contracts tend to have more strikes and expiration weeks and months to choose from. That gives an investor more selection when looking to initiate strategies, including spreads, that involve more than one contract, or when pursuing a specific option cycle tied to events like earnings or dividends, for instance.
In addition, a busy market with many participants typically has narrower spreads between the bid prices and the ask prices. More customer orders increase the likelihood that investors can trade with each other, rather than having the market maker take the other side of the trade. Liquidity is especially important for active traders in fast markets and/or near expiration dates, because that’s when opening or closing a position might be a more pressing issue.
Ultimately, traders are a little like wine collectors—liquid assets matter. Remember, in today’s fragmented options market, the lion’s share of action is confined to a relatively short list of names. Volume and open interest indicators can help you identify liquid opportunities, especially for spreads and other multi-legged option plays.