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The importance of liquidity in options

How option liquidity works and what effect this can have for the investor

Written by Peter Siks | 5 minutes
THU 06-08-2020

For a small  - with all due respect! - Option investor this will be a topic of which he or she thinks "whatever". However, this is not justified in most cases. The liquidity of options is important for almost every investor  in options. In this article, I will discuss several factors that influence the liquidity of options and what the (possible) consequences are for you as an investor.

The underlying asset
An option is a derivative instrument and the better the liquidity in the underlying instrument, the better the liquidity in the derivative will be. To determine whether an underlying asset is liquid, you can look at:

  • What is the average volume of a fund?
    In the screenshot below you can see that you have the option to show the average volume.
  • What is the share’s bid-ask spread?

And you understand: the smaller, the more liquid.

  • Is the underlying value quote driven or order-driven?
    Think of quote driven, for example, ETFs where market makers issue quotes for that ETF and thus provide liquidity. Most shares are order-driven. This means that all orders from all market participants are liquidity.
  • The price of the underlying asset
    This does not always apply, but the liquidity of 'expensive' funds (Adyen) may be lower than 'cheap' funds (Aegon, PostNL). This may affect the liquidity of the associated options.

The type of option market
The Dutch option investor is used to 'full option screens'. The Amsterdam options exchange has always done its best to ensure that there is a visible quote for each option series. This does not have to be the case for other markets. It is also possible that we work with a 'request for quote'. Then a quote must be requested. The bid and ask prices are not visible before. This does not benefit liquidity because an investor has no exact idea where the option price is located.

Also, it is important whether the market makers are obliged to set (offer bid and ask prices) or whether they receive benefits if they set. For example, think of more bandwidth towards the stock market or a discount on the stock market costs if, for example, they are present in the market with quotes more than 99% of the time. Finally, many stock exchanges have the option to switch to a different market type: the so-called 'fast market', where relaxation of certain rules applies. For example, it may mean that spreads may widen and that the volume of bid and ask prices may be smaller in these special market conditions. A fast market can therefore be negative for option liquidity.

 

The options themselves
There are still a few things to keep in mind to estimate the liquidity of the specific option series. Below you will find some:

  • The option's bid-ask spread
    As a guideline, you can use a difference of less than 1.25% of the underlying asset as liquid. So if a share costs € 50, a difference between the offer and ask price of € 0.62 can still be classified as liquid according to this rule.
  • The duration of the option
  • How many options have been traded on the day itself
    You will find this column under 'Cum. volume'.
  • The ‘open interest’
    This also tells you something about the liquidity of the option. These are the number of outstanding contracts of the relevant option series.

Liquidity is elusive
It is important to realize that liquidity is always a snapshot. Certainly, if the underlying shares move strongly, this can affect the liquidity of the derivative instruments. In that sense, liquidity is fluid: one moment present ,and the next moment it can disappear like snow in the sun. In practice, this may mean that there are still quotes, but that the spreads are much wider and that the volume that can be traded on those prices is much lower. This was very clearly visible in a number of cases in March and April 2020.

The consequences for you as an investor
It may of course be possible that you only trade in (very) liquid options. That's nice: you know that you can easily place large option orders - on a tight spread - that have little to no market impact. Especially with less liquid options, it is important for you as an investor that you do not work with too large orders and that you limit sharply (but realistically). It is not wise to trade at best in liquid options series!

And especially in less liquid option series, hectic in the underlying share can result in less liquidity in the options listed on that share. Certainly, if you have to act (for margin reasons, for example), this can be very annoying. So keep this in mind when taking position: is the fund liquid enough so that I can get out again in a normal way?


Conclusion
The Dutch option investor invests in one of the most mature option markets in the world. Full screens, almost always tight spreads and sufficient volume. But markets can change quickly, we saw that in March this year. Then the liquidity can suddenly look very different. Keep this in mind, of course, you do not want to be faced with unpleasant surprises!


Options are high-risk products and require knowledge, investment experience and, high- risk acceptance in many applications. Before you invest in options, we advise you to inform yourself properly about the effect and risks. You can find more information about this in the Binck document center in the Derivatives Manual. You can also consult the Essential information document (Eid) of the option in which you want to invest on the BinckBank website. You can only trade options if you have concluded the derivatives agreement.

Author

Peter Siks

With more than 30 years of experience, Peter Siks has now been tried and tested in investing. Among other things, Peter is interested in the psychological aspects of investing and since 2010 he has been working at BinckBank as an investor trainer.

The information in this article should not be interpreted as individual investment advice.  Although BinckBank compiles and maintains these pages from reliable sources, BinckBank cannot guarantee that the information is accurate, complete and up-to-date. Any information used from this article without prior verification or advice, is at your own risk.  We advise that you only invest in products that fit your knowledge and experience and do not invest in financial instruments where you do not understand the risks.

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