Stock options is a derivative trading instrument where you can utilize it to
trade the underlying stock at a fraction of the cost of buying the actual stock
itself. Although stock option provides leverage in terms of higher profit
returns, it is an expiring trading instrument. Unless your option trading
technique is able to lock in a profit during the life span of the option, your
option contract could expire expire worthless if you are not able to anticipate
the desired movement of the underlying stock in the short-term accurately.
Although you can now trade a wide selection of stock options since many
stocks have become optionable, it is better to keep out illiquid stock option
from your options trading choices. Illiquid stock options are options which are
not heavily traded. Such low trading volume is originated from the equally low
trading action of the underlying stock. Your first major disadvantage in trading
illiquid stock options would be the wide bid and ask spread slapped on you the
very moment you entered the trade. The other drawback is, let's say you have
purchased an option in anticipation for an event (eg. earnings, acquisition
announcement) and subsequently the underlying stock made a price movement in the
desirable direction, your profit might still be curtailed because the wide bid
and ask disparage would be worsened by the collapse in implied volatility right
after the event. Moreover, if you are holding illiquid stock options and you
wish to offload them urgently, you are compelled to sell them at market order at
the already disadvantaged bid price due to the low demand and supply of such
options.
So how do you determine whether a stock option is illiquid? As mentioned
earlier, they would have a wide bid and ask spread. The slippage could sometimes
be a difference of $0.30 or more, where the market makers made a tidy profit
from the spread just by providing liquidity to investors of such stock options .
The average daily trading volume of the underlying stock of such illiquid stock
would usually be low, typically less than 200,000. The other way to spot
illiquid stock option would to look at the trading volume and open interest of
the different options series, which would usually be very little or sometimes
with no trading volume.
On the other hand, it is more cost effective to trade stock option with high
liquidity (ie. high trading volume) since you get not only a tighter spread
(sometimes as low as $0.05) between the bid and ask price, you are also able to
fulfill your option trade with a limit order. The underlying stocks of such high
liquid stock options usually have with an average daily trading volume of at
least 1,000,000.
Thus, it is advisable to avoid trading illiquid stock options due to the
reasons mentioned above, unless you are very familiar with the price movement of
the underlying stock and the profit achieved is able to cover the wide disparage
between the option bid and ask spread.
