[#Market]. Introduction to #Options – #Liquidity (Market liquidity as a leverage for investors contrary) In the previous article in this Rich Dad Education Introduction to Options #series, the bid-ask spread was discussed. It is important for new Rich Dad Education #students to have a firm understanding of the bid-ask spread for two reasons. #First, understanding the bid-ask spread can potentially save you transaction costs on your trades by knowing you can get better prices from the market makers. Over time, the little saved on transaction costs can start to add up and represent significant savings. #Second, and perhaps more importantly, when a Rich Dad Education student understands how the bid-ask spread works, they gain greater insight into how the market works. Once you gain a full understanding of how the market works, you come one step closer to becoming an elite trader. Options Liquidity Understanding the concept of liquidity and how it affects your trading is an important early step for Rich Dad Education students new to trading. As you start to study charts, you will see potentially good trade setups that you may want to trade. In a perfect world, once you identify the entry point to one of these trades, you want to get in at the ideal entry point and the best price possible. Conversely, when you identify the moment to exit a trade, you want to act at the ideal exit point and get the best price as well. Understanding liquidity can help you achieve these ideal circumstances. Liquidity for options traders is the ability to get quickly into or quickly out of a position that has a very small difference between the bid and ask. A highly liquid market has an abundance of buyers and sellers, allows orders to quickly be filled and enables traders to easily exit their positions. Because of this, some traders establish rules that only allow them to trade options on stocks that have certain volume requirements. These requirements will vary according to the trader, but common standards include 500,000 or one million shares in average volume daily. The higher the volume, the more liquid the option contracts will be. Liquidity on Option Contracts In addition to identifying volume on a stock, there are several other ways to identify whether the particular option contract you want to trade is highly liquid. These additional methods include option volume and open interest. Option volume tells you the total number of option contracts that have been bought or sold for each and every strike price for the trading day. Open interest is another way to determine option liquidity. Open interest tells you how many open positions (contracts) there are in a particular options strike price. This is the total number of contracts that have been bought or sold and not closed out. For example: Let’s imagine that you were the only individual trading a particular option strike price. If you purchased 50 contracts on a particular call option and were the only buyer, then today it would read: Daily Volume = 50 The next day if the contracts were not closed out and you did not purchase any additional option contracts, then it would read: Daily Volume = 0 Open Interest = 50 If a new trader came in and was interested in that particular strike price, they would see that there is indeed activity surrounding it. The higher the open interest, the more activity and potential liquidity there would be surrounding that option strike price. High Open Interest – High open interest decreases the chance of market maker manipulation. It can also show that there is a lot of demand for a particular strike price. High open interest on calls over puts indicates that there may be a market bias towards the underlying stock. Many traders have rules where they insist on at least 50 or 100 open interest before they will even entertain trading the option in question. Similar rules relate to the percentage of open interest that a trader owns, which usually is capped at 10%. When selling options you do not have to worry about open interest. Even in the beginning stages, Rich Dad Education students need to take the time to understand liquidity and how it affects their options trading. While not common, there are horror stories of new traders that buy too many option contracts at a strike price that had little liquidity. The most frustrating of these stories involves new traders that were right about their prediction of the stock’s movement but couldn’t maximize their profit because there were no other traders interested in that particular option, and hence no liquidity. Take the time to establish a few simple rules that will help you avoid this frustration.
Posted on: Tue, 10 Sep 2013 04:28:54 +0000
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