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Morning Mailbag: Option Liquidity

June 25, 2015

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Welcome back to a series I enjoy writing: the Morning Mailbag! This edition involves questions about option liquidity and credit spreads.

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From Matt in Colorado:

Tim,

I’ve been watching the TT shows and reviewing some of my class notes and lab notes.  When everyone talks about option liquidity, I think the guidelines get a bit fuzzy:

  1. Bid/Ask spread:I’ve been using the following guideline:  10% or less as defined by the following formula:  (ask-bid)/ask.  Is this right?I notice that as you move further OTM, the bid/ask usually widens; I assume that means we’ll have to examine bid/ask for every strike we consider, not just the ones ATM or close to it?
  1. Volume:  I know we look at volume and want to see some action, but it resets daily; so I’m okay with watching that. I assume that if I consistently see “0” during the day then that particular option isn’t liquid?
  1. Open Interest:  I have started to notice that some stocks have strikes with very little open interest, but other strikes have a lot of open interest (i.e., FLR). So, the size of my spread may be determined by which strikes offer sufficient open interest? In my current state of ignorance, I would guess that:  entering a vertical spread with one strike good on open interest and the other strike not-so-good, will cause crappy fills if I want to get out of the spread early (buy-back at 5 cents / hit stop loss)?

Any other notes/guidelines on liquidity are welcome.

Thanks,

Matt

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Hi Matt,

1. Yes, 10% of the spread is a standard measure. However, anything over .50 is pretty tough to consider. I’d say keep it .30 or less, as well.  And yes, as you go OTM, you have to consider the spread for every strike you have.
2. Volume can be an okay measure of volatility, but it can also be misleading. As long as the bid/ask spread is tight, I consider taking the trade.
3. OI.  Good catch on that. If one of your legs is illiquid, it can make it harder to get a good fill when getting out.
I think you have a generally good idea on liquidity. The best plan for most traders is to trade the most liquid stocks when using spreads.
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Hi Tim,

Hope you are enjoying your summer!1) Do you use alerts? Do you have a rule for where to place them?2) Right now I use my regular trading account until I use up my funds and then switch to my IRA. Should I have a better strategy than that?

3) Do you have advice for your students who want to retire from employment? Should I have a certain number of years of experience? Certain number of trades? Make a certain amount of income?

4) I see that there can be a loss for a position at first based on the prices I choose to pay, even if the parameters are all correct, and over time the loss turns to profit. For example, if the stock is above the strike prices for a bull put spread from the very beginning, there can still be a loss at first. A) Is that due to theta? Is that true for all strategies (whether positive or negative theta)? B) Is there a way to tell before entering the trade how much the loss at the beginning will be? Should I care?

5) Why does the risk graph for a bull put spread not look like a combination of a risk graph for a long put and a short put?

6) Do you have a net credit rule for the iron condor?

Thank you very much and have a great day!
Julie in Alaska

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Hi Julie!

1. Yes, I use alerts.  I set them 1/2 of the ATR form the strike I sell.
2. I think it’s smart to use your trading account and your IRA.
3. I’d recommend to stay employed until you’re certain you’re ready. Usually a few years of consistency is a good.
4. Great question on theta. Yes, time can benefit your position, but only for positive theta strategies such as naked puts, covered calls, bull puts, bear calls, and iron condors. You can start a trade down if your fill price is below the mid point price.
The risk graph on the bull put is the combination of the short put and long put.  However, think about where we’re buying the put: its at a lower strike, which is why the bottom left of the graph is simply a flat line.
Net credits for iron condors should be about 15% or more for .10 delta short leg iron condors.  If you go up to 20 deltas, you would need 30% net credit.
Tim

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2 Replies to “Morning Mailbag: Option Liquidity”

  1. Avatar PatrickDonegan says:

    Tim,
    Your statement, “…Net credits for iron condors should be about 15% or more for .10 delta short leg iron condors. If you go up to 20 deltas, you would need 30% net credit,” leaves me a little lost. Please explain this a little further. I think I missed this in the iron condor explanations. Thanks, in advance.

  2. Hi Patrick,

    Thanks for reading the article. The higher delta you use on the short leg you sell should increase your overall ROI numbers. Traders that use .05 deltas will get smaller credit amounts than traders that use .20 deltas. The higher the delta you use, your expectations for a higher ROI will go up.

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