Why do you trade Liquid Options

LiquidityWhen we say you will only benefit when you sell liquid options, why is that? Liquidity are most active options. Liquidity is an important concept for traders. Let me explain why. If you can understand water and ice analogy than you are almost there.

When you open a tap running water comes out of it. You can fill up a swimming pool with the water. On a hot summer day you can dive into it and come easily out.

On the other hand when it is winter and it is very cold water on the lake got be frozen. It is not easy to dive into the lake and go for a swim.  You might want to go for ice skating. Newly frozen ice may have weak spots. Sometime the ice crack and a skater falls in. For him/her it is difficult to climb out.

Options Liquidity

One of the most important considerations with options is that of liquidity. The definition of Liquid Options is how easily an investor can buy or sell an option or an asset without losing much value. The more an asset is traded, the more liquid it becomes.

We want to trade only 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. We prefer to sell liquid options with high Implied Volatility so that they will have rich option premium.

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 fast. 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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Option volumes can vary dramatically between the various underlings available. Consider the case of AAPL options which have trading volumes in excess of several millions of dollars each and every day; this is to be contrasted to the numerous underlying stocks having thinly traded options that trade only occasionally and by appointment only.

It may be possible to negotiate a reasonable price to enter a position, but if you need to exit, you can expect to leave a dollar or more on the table.

Video on Liquidity

We are sellers of options that have high Implied Volatility. We want to receive much option premium. Selling Options have a better probability of profit. We select options which are liquid. If you want to learn more on liquidity below is a video where Tom and Tony talk through in depth.

Liquidity

What I have learned from them is that you should first look if there is enough contracts traded in the stock option. And not trade products with a very wide bid ask spread. It is very important when you sell option premium that you can enter and exit the trade fast. Increase your trading capital faster by managing your trades early.

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