Liquidity Measurements

Today we continue our liquidity discussion with an emphasis on how to measure it. Upon completing the first piece of our two-part liquidity series you should understand why it is terribly important to limit yourself to trading the most liquid options.

So how exactly do we gauge an option’s liquidity? Three popular metrics are easily found on an options chain – open interest, volume, and the bid-ask differential.

Open Interest

Open interest measures the amount of option contracts currently open and floating around the world. When an option begins trading it starts with an open interest of zero. Then, as contracts are both bought to open and sold to open, the open interest begins to rise. As more and more contracts are opened the open interest continues to lift.

Now, open interest can decline as well. This occurs when option contracts are both sold to close and bought to close.

High open interest reveals an option is actively traded. The higher the open interest the better. As a minimum try limiting yourself to trading options where the open interest is at least 100. Some of the most liquid options have open interest over 10,000.

Volume

Volume simply measures how many option contracts are traded today. It resets to zero each day and builds throughout the trading day (if the option trades, that is). You can’t really pass judgment on volume until the middle of the day when the contract has had time to be bought or sold.

The last thing we want is to be the only trader in the world trying to buy or sell an option throughout the day. Instead, we’d like to be a small fish in a big pond. I want to be buying 5 or 10 contracts on an option that trades 50 to 100 contracts a day, if not more.

Bid-Ask Differential

The bid-ask differential (sometimes called the bid-ask spread) refers to the difference between the bid and ask price for an option.  As traders, we can buy at the ask price but have to sell at the bid price. Of course, you can try to use a limit order to get filled somewhere in the middle, but that’s a story for another day.

Simply put, liquid options have a narrow bid-ask spread while Liquid options have a wide bid-ask spread. We prefer trading options with a bid-ask differential around $0.20 or less. So for example, if the bid is $5.00 and the ask is $5.10 then we’d consider the option liquid by bid-ask spread standards.

The $0.20 or less threshold applies to cheaper options, however. The more expensive the option the wider the acceptable bid-ask spread. A call option on Amazon.com, Inc. (AMZN), a $390 stock, has a $17.30 bid, $17.60 ask. A $0.30 spread in other words. That’s acceptable for an option that’s almost $20.

Here’s a screenshot of call options on the S&P 500 ETF (SPY), a super liquid vehicle. Note the open interest on every strike is over 10,000. Despite being early in the morning when I took the picture a number of the strikes already have hundreds of contracts traded today. As a result of the elevated activity the bid-ask spread on most of these options is 2 to 3 cents wide.

Do yourself a favor and stick to the liquid stuff. Though options are listed on over a thousand stocks and ETFs only a hundred and fifty or so are liquid enough for active traders.

Using liquidity as a filter for adding stocks to your watchlist is smart. And, it will narrow down your universe of stocks from thousands to a mere hundred or so that are easier to track.