Tuesday, 25 February 2014

Always Chose Liquid Counters to Trade Options

Simply put, liquidity is all about how quickly a trader can buy or sell something without causing a significant price movement. A liquid market is one with ready, active buyers and sellers at all times.Here’s another, more mathematically elegant way to think about it: Liquidity refers to the probability that the next trade will be executed at a price equal to the last one.Stock markets are generally more liquid than their related options markets for a simple reason: Stock traders are all trading just one stock, but the option traders may have dozens of option contracts to choose from. Stock traders will flock to just one form of DLF stock, for example, but options traders for DLF have perhaps six different expirations and a plethora of strike prices to choose from. More choices by definition means the options market will probably not be as liquid as the stock market.Of course,
DLF is usually not a liquidity problem for stock or options traders. The problem creeps in with smaller stocks. 
Take First Source an (imaginary) environmentally friendly energy company with some promise, but with a stock that trades once a week by appointment only.If the stock is this illiquid, the options on First Source will likely be even more inactive. This will usually cause the spread between the bid and ask price for the options to get artificially wide. For example, if the bid- ask spread is Rs 2 (bid=RS 10, ask=12), if you buy the Rs 12 contract that’s a full 20% of the price paid to establish the position.

It’s never a good idea to establish your position at a 20% loss right off the bat, just by choosing an illiquid option with a wide bid-ask spread.

3 comments:

  1. I agree with you to opt always this technique for trading in option, as people are not aware of it fully but this technique is becoming famous day by day.

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  2. Its good to be here, very nice post, the content is amazing, keep posting friend it will be very helpful for everyone, Thanks for sharing. I really liked it.you can also read Check nifty

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