Liquidity Of Options

The Smart Profits Report: Issue #116
Tuesday, June 8, 2004

Liquidity of Options: Protect Yourself Using Limit Orders When Trading
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

One of the questions that people considering options ask me all the time is, “Are options liquid?” It happened again just a couple of weeks ago at one of the conferences I was helping to host. And here’s my answer… Some are, some aren’t. And it makes a difference to your results.

The liquidity of options, or ability to buy and sell an option at a fair price and reasonable spread, is directly related to the underlying security. If the security is liquid then nine times out of 10 the option will be, too.

For instance, in one of my trading services, I recently recommended buying and selling Toll Brothers put options. We were betting that interest rates would move up and housing shares would fall. We were right about that. Housing shares did fall as rates moved up. But the Toll Brothers option was not as liquid as the underlying stock.

There were two reasons for that:

First, the option was one that not many people knew about or owned, so it was relatively thinly traded, even though the stock has a good following.

Second, the underlying stock is extremely volatile, which resulted in a very large spread between the bid and the ask. A large spread is an indication that the option may not be as liquid as you think.

We prevailed over the wide spread, however, by using strict limit orders as I’ve discussed in earlier Smart Profits Reports.

In fact, limit orders will likely become one of the most powerful weapons in your options arsenal, both offensively and defensively… Let me explain…

Liquidity, Spreads & The Market Maker

Large spreads usually mean that the market maker is glad to see you coming. He’ll tweak the price as high as possible. But he’ll still set it so that you’ll be willing to enter the trade.

It’s when you’re ready to exit that he clips you. Illiquid options usually mean there are few other interested buyers and sellers. And when it’s just you and the market maker in a face-off, you’re at a big disadvantage. If you’re in a hurry to exit at any price, he feels your desperation and will move the bid lower aggressively. Or you may see the dreaded “no bid.”

The antidote if you find yourself in this situation is that all-around good practice, the limit order.

At the very least, you will protect yourself when getting into a trade with a limit order. It will ensure that if you get filled on your order, it will be at or below your limit price.

And if you don’t? Good! It is far better to miss a trade than to pay so much you have very little chance of profiting even if you are right about the underlying stock.

Don’t fall into the trap of “playing options.” Remember, the goal is to MAKE MONEY. If you don’t get a fill, it was probably a good thing because you probably wouldn’t have been able to exit gracefully, either.

Use Limit Orders for Entering AND Exiting a Trade

And when you close your trade, use a limit order again. But be reasonable. This time, you don’t want to risk not getting your order filled. You have to sell to make a profit. So set your limit midway between the bid and ask, or slightly higher than the bid, if there’s a wide spread.

If the spread is reasonable, set it at the current bid just to ensure the market maker doesn’t start dropping his bid as soon as you show up.

I make this a practice, even when there aren’t any apparent liquidity problems.

For instance, a few days ago we bought call options on another company in my trading service (I can’t reveal the name of the stock, since it is an open position).

In this case we had used a strict limit order to buy the options at the current offer price. We weren’t so much interested in shaving a few cents off the price of the option as avoiding having the market maker start raising it when he saw the volume of orders coming.

It worked very well. I would estimate, judging by the volume, that all of my readers were filled at or below the limit price within a couple of hours of the recommendation. This issue was extremely liquid with over 2,000 contracts offered at our limit price across all exchanges. But the same practice is even more important when fewer contracts trade.

Rest assured, a good trading service will not recommend illiquid issues. It makes no sense to recommend that you invest in something that you cannot buy. It is bad faith on the part of the editor and a very poor business decision to boot.

Good Trading,

Karim

Today’s Smart Profits Crib Sheet

In today’s Report, I talk about the options-trading services I edit. One focuses on long-term options (or LEAPS), and the other focuses on an options strategy we’ve discussed in this space before: covered calls. For more information on either fast-paced service, please visit The Income Trader: A Covered Call Strategy and The Options Trader.
Pop over to our Smart Profits Glossary if you have a question about any terminology used in today’s Report, such as “liquidity” or “limit order.”

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