Considering The Options Liquidity

• The bid/ask spread.
• The volume.
• The Open Interest (OI).
• The strikes.
• The time to expiration.

Let's examine those five factors one by one.

The bid/ask spread

This is obviously one the more important factors. The thinner the spread between these two points, the more efficient the ability to buy and sell in a shorter time period, and the more likely you are to make a profit over time. This is basically the spread between what we can buy something for and what we can sell it for is one of them. Our goal is to be able to trade as close to the midpoint as possible.

CBOE (Chicago Board Options Exchange) has a program called PPP which stands for Penny Pilot Program. Prior to the start of the PPP, options would trade no less than the five-cent spread (bid .95/offer 1.00). This program started with just a few stocks that started trading options in the pennies. Now there are more than 300 stocks on the penny list. This list can be found at https://www.cboe.org/hybrid/pennypilot.aspx. It is fairly safe to assume that stocks participating in this program will have a decent liquidity.

When looking at the bid/ask, we also need to consider the price of the underlying and the option. For example, At-the-money (ATM) option on a stock like GOOG can trade at 27.00/27.30. That's a 30 cents spread, but it represents only 1% of the option value. Assuming that we can buy at 27.20 and sell at 27.10, that's only 0.3% slippage. On the other hand, a 30 cents spread on a $3 option (3.00/3.30) represents 10% of the option value. Even if we are able to buy at 3.20 and to sell at 3.10, this is still a 3% slippage.

The volume

Usually there is a direct correlation between volume of the options and how thin the spreads are between the bid & offer of these options. Like with spreads, the underlying price should also be considered. 1,000 contracts of MSFT are not the same as 1,000 contracts of GOOG. What is more important is the dollar value of the volume. For example, 200 contracts of a $20 option represent $400,000 volume - I would consider such volume more than enough to trade those options.

The Open Interest (OI)

The OI usually has similar impact on the liquidity as the volume. Again, we need to look at the underlying price to compare apples to apples. For an average stock, I would typically look at few thousand contracts of OI. At higher prices stocks, 500-1000 contracts might be enough.

The strikes

There are three types of options strikes:

• In-the-money (ITM) options the most expensive, and the bid/offers usually widen.
• Out-of-the-money (OTM) options have no real value, they are cheaper in price at this level and offer thinner spreads.
• At-the-money (ATM) options tend to have the most volume, and the spreads are usually the tightest.

The time to expiration

Expiration dates vary from a week to longer than a year.

LEAPS are options that have between nine months to over two years to expiration. On average, they have some of the lowest volume, and that means the spreads are generally wider here — meaning they are not the best choice for a short-term option trader.

Quarterlies. These are options that expire on the last business day of each calendar quarter (March, June, September, and december). They are very liquid because they are traded by multiple–time frame traders.

Monthlies. These are options that expire on the third Friday of each month. They are very liquid because they are traded by short- and intermediate-term traders.

Weeklies. These are short-term options that expire each Friday. They aren’t as liquid as the monthlies, but as they get more popular, they are gaining volume. According to the CBOE, currently, nearly 18% of all equity options traded are weekly options.

Paying attention to liquidity will minimize our slippage and significantly improve our chances to make money over time.