The Liquidity Trap of Options Trading

11/07/2014 8:00 am EST

Focus: OPTIONS

Bob Lang

Founder and Chief Analyst, Explosive Options

For Bob Lang, of ExplosiveOptions.net, it seems that open interest is limited to a small number of participants willing to be option market makers these days, so he explains how he’s been using weekly options, the newest product to be used the most lately to spot liquidity.

As stock derivatives, options offer traders some tremendous opportunities to play high-priced stocks or very active/liquid securities. Options are not only offered on equities but indices, futures and commodities as well. Market makers even use options as hedging vehicles (but that only works best when there is a lot of interest).

The issue of interest brings me to the liquidity trap. These days, it seems that interest is limited to a small number of participants willing to be option market makers. We’re not talking about highly liquid names like Facebook (FB), Microsoft (MSFT), Intel (INTC), and Apple (AAPL). Instead, we are talking about off-beat names that have good price action but lack the punch of strong volume. (Note that the two most important indicators are price and volume. Some stocks have so little volatility that the options market is completely ignored. When that happens, the spreads create an impossible entry point.)

The main issue is, am I able to get in and out at a fair price or am I being taken for a ride? Can this situation improve so more can participate?

Take a look at a name like Priceline (PCLN), a four digit stock that trades well under the float and is clearly held by institutions and insiders. They don’t care about the options market and that is evident by the lack of interest in the name across all strikes. The November 1150 monthly strike has about 850, which is the highest amount of any strike (the rest are far lower). These prices are high across the board and pretty much freeze out any buyers.

But let’s take a look at another name, Red Robin (RRGB). The chart was looking good before earnings were announced, but if you look at open interest, the highest level was the 60 strike, which had less than 300. The stock trades well under 1 million shares a day, but the lack of interest caused the spreads to be wider than a semi-truck. I had to pass.

After Red Robin’s earnings were reported on Tuesday, it appeared the stock was ready for a bigger move. The stock was up $6 when I first looked at it, continued to climb through the day, and, on Wednesday, it pushed up 4%, yet options provided little wiggle room for an entry or exit (the Nov 60 call on Wednesday had a horrid bid/ask spread of 5.2 x 7.90). Market makers can act egregiously, and yes, it’s because they really do not want to let you in the game. Red Robin is just one example, but this is symptomatic of many names out there.

So, with little liquidity in names, you get less volume, yet we see the biggest market maker, CBOE, hitting new highs day after day. Where is the liquidity? I see it in weekly options, the newest product, and the one that is used the most lately. In addition, VIX and index options have been seeing quite a bit of daily activity, but the story is the same. For the little guy, it is nearly impossible to participate. Liquidity is our friend…until it’s not.

By Bob Lang of ExplosiveOptions.net

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