Liquidity of an options market is possibly the single most important metric to confirm prior to trading. Determined by the number of traders in that market, its an expression of how easily an option contract changes hands. Liquidity is determined in one of three ways; volume, open interest, or the bid/ask spread. If all three suggest the desired option is liquid a trader can be relatively sure the trade is safe. Now, that isn’t to say the trade won’t lose money, it certainly can. What it does signal, is that a position can be easily traded within the market.
Most options traders understand liquidity through an options bid/ask spread. However, good practice is to view all three criteria prior to entering a position. If you find yourself stuck in an illiquid trade you’ll quickly understand what we mean. Liquidity is but one of the myriad of risks facing an options trader each an every trade.
To say it another way, liquidity is the traders ability to enter into or exit a position without the need for exercise or assignment. Without a firm percentage estimate I’ll avoid the usual “90% of all options trade within the options market” declaration. But i think most will agree, the idea is to achieve our profit target prior to expiration.
At OptionID, no illiquid option trade will be discussed. Further, trades that don’t meet liquidity criteria will be removed from consideration.
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