If you truly want to make more money trading options then you need to start thinking now about the options you trade now. Liquidity should be combined with other metrics as you perform your market research but some traders overlook its advantages.
In this post I wanted to share some of reasons why an option liquidity should be a top priority as you scan for new trades.
1) Volume = higher liquidity
The more option volume there is a for contract typically the more liquidity will exist. These contracts are then much easier to move in and out of. This can be important if you need to move in and out of your position quickly.
2) Buy and hold is a fallacy
Old school investors buy "good quality" securities, and then hold them. Not so with options trading. When you see an opening to secure a nice profit – you want to be able to take it. Ensure that options liquidity is high before you execute your order.
3) Allow for adjustments
If it is difficult to open a contract because of low trading volume, chances are, it will be equally difficult to close a contract out. This can make fine tuning your investment strategy challenging.
4) Options interest as a sign of liquidity
As you enter into an options position, the transaction is an opening, or closing one. Buying 10 calls for instance is an opening transaction. When you sell your position, you are typically closing the transaction. High open interest signals high liquidity.
5) Wider bid/ask spread signals more risk
The wider the spread, the larger the price move in the contract is needed to realize a profit or loss. Since the spread is wide it means that the exchanges have to make up the low liquidity with wider profit margins.
6) Determine your risk tolerance
Implied volatility can be a good metric in determining risk exposure. The higher the volatility, the higher potential for big moves – up or down. High liquidity tends to equal lower implied volatility.