Let’s say I’ve picked a very liquid stock (1 million shares average daily volume) with little option liquidity. I’ve bought 10 contracts for $3.00 and there isn’t any buying or selling interest in the options. Before expiration my position is 10 points in the money. Will this trade be profitable? Do I need buyers to sell my contracts to, or will the OCC be obligated to buy the options from me no matter what the situation is? Will the liquidity for that particular option change the price of that option if its 10 points in the money?
After a recent quadruple witch, I thought this article could benefit option traders so I pulled it from the archives.
When you purchase an option you have the right to buy shares of stock at a specified price (the strike price) within a specified period of time (the expiration date). The liquidity of an option does not change the contract specifications. The seller of that option is obligated to deliver shares of stock to you at the strike price if you choose to exercise your right. The OCC (Options Clearing Corp.) performs many functions. One of them is to balance trades. They know the net contract position for every brokerage firm for every option. The brokerage firms are required to post margin with the OCC for their open positions. If the seller of your option defaults, the brokerage firm is liable. Without getting into SIPC and supplemental brokerage insurance topics, let me state that someone is going to make good on that obligation 99.9% of the time.
Now let’s talk about the implications by putting some hard numbers behind the scenario. You have purchased 10 front month $50 calls for $3 and the stock is trading at $60. The options are no-bid offered at $20. While this would never be the case, let’s explore the situation. You have the right to buy the stock at $50. All you need to do is to sell 1000 shares of stock at $60 in the open market and simultaneously notify your brokerage firm that you want to exercise your calls. By notifying your brokerage firm, you will not have to post the short margin reqiurement for the short sale of stock. this proceedure is known as a “same day substitution”. Overnight, you will be buying shares at $50 and you will have sold shares at $60 and your account will realize a net difference of $10. Given that you purchased the options for $3, you made a $7 profit on the trade. No matter how illiquid the options are, they will always have an intrinsic value once they are in the money. If the option markets are unfairly wide, you can circumvent the Market Makers all together. For more information on this topic, please read my post Avoid The Option Expiration Rip-Off!.
As for the liquidity affecting the price of the option, yes there is an impact. The bid/ask spread becomes very wide and the Market Makers won’t play between the bid/ask. They don’t want to take the other side of the trade because they know that they can’t hedge using other options since they don’t trade. Their only recourse is to offset their risk using the stock. They will have to carry the position for a long time and they will not be able to leg out. Consequently, they will build in more profit by keeping the bid/ask spread wide. When the options are at the money, they can really toy with the price of the options by adjusting the implied volatilities. In a situation where the market is $2.50 x $3.00, you are giving up a big 25% edge. Slippage will play a huge role in your profitability and it needs to be considered.
As a rule of thumb, I don’t like to trade options that are only listed on one exchange. It gives that particular Market Maker an unfair advantage since he knows he will see every order coming and going. I also don’t like to trade options that have a bid/ask spread that is greater than $.40. Finally, I like to know that I can get at least 100 contracts executed on the bid or ask. That size is available on most option quotes systems. If I have a very compelling trade and liquidity is an issue, I will go far out in time so that I don’t have to worry about rolling the position as expiration approaches. These illiquid trades need to be long-term position trades.
The exchanges used to have rules in place that dictated how wide a bid/ask could be on a particular option. Those rules were put into place to insure “fair play”. Unfortunately, they are no longer in place.
Most educators will tell you to avoid illiquid options. For the most part, that is sound advice. However, I feel as a small trader, you can take advantage of thinly traded situations. Big institutions won’t give them a second look because they can’t get enough size done to make it worth their time. On the other hand, a 10 contract trade can produce nice profits for a small trader. This is one of the advantages of being a little guy and I am careful not to part with any edge that I have. Many Asset Managers will tell you that the more money they have to place, the tougher it is for them to maintain their performance. Trust me, being a small trader can actually be an advantage.