The Most Important, but Overlooked, Option Trading Tool

12/20/2010 10:41 am EST

Focus: OPTIONS

Of the numerous trading concepts vying for an option trader’s attention, some are admittedly more intriguing than others. The VIX, “volatility skew”, iron condors, and other terms and complex spread trades tend to have more sex appeal than boring old things like liquidity and money management.

As such, the former items tend to receive more face time, while the latter are swept under the rug. Unfortunately, in many traders’ hurried attempts to grasp the exotic, they fail to spend sufficient time learning the more mundane and basic trading strategies.

While the significance of such a decision may not seem monumental, trading success is largely dependent on a grasp of the essentials. To that end, here are a few thoughts on the often-overlooked yet fundamental concept of successful option trading: Liquidity.

  1.  Liquidity is often defined as the degree to which an option can be bought or sold in the market without affecting the option’s price.

  2. Liquidity is driven by trading activity, hence, options with more trading volume offer superior liquidity than those with low activity.

  3. Liquidity is reflected in the bid-ask spread of an option with the most liquid options having the tightest spreads (i.e. SPY, QQQQ, USO) and the least liquid options having the widest.

  4. Stocks and ETFs with high volume tend to offer more liquid options than those with low volume.

  5. The bid-ask spread of an option is also affected by volatility. In times of extreme market volatility (think Flash Crash), the spreads can widen enough to make options virtually untradable.

Trading is hard enough without having to overcome the large bid-ask spreads inherent with illiquid products. So do yourself a favor, dear option traders, and make sure liquidity is one of the top criteria you use when selecting a security to trade.

By Tyler Craig of TylersTrading.com

Related Articles on OPTIONS