When selling options, liquidity is an absolute necessity. With this post, I would like to continue our small series about the comparison between futures options and stock options. This time, we will explore where we find more liquidity, whether in futures options or in stock options.
I want my cash back and I want it quick
I am sure the majority of readers will know what “liquidity” means. For those who do not, liquidity basically describes how quickly you can get your cash back. In other words, how many buyers and sellers are in the market, ready to trade with you. The more buyers and sellers you find, the more easily you can close your position. In general, financial markets are very liquid. This means, you can close your position and get your money back within seconds. However, you will find many different levels on liquidity even in the financial markets.
Popularity attracts buyers and sellers
Options are not as liquid as the underlying assets, be it stocks or futures. Nevertheless, you can find a good liquidity in both futures options and stock options. In particular, if you know where to look. For stock options, the number one market is the U.S. stock market. I do not know about any other stock market, where you can trade individual stock options so reasonably. Sure, you can sell options on European stocks as well, but there is very little going on. Non-liquid markets result in very large spreads between the bid and ask price which is a considerable disadvantage. Getting back to the U.S. stock market, the best liquidity is in stocks which are currently trendy (very popular). Those are at the moment technology stocks such as Alibaba, Apple, Nvidia, Netflix, Tesla and so on. In many other stocks, the bid and ask price are further apart.
I would like to illustrate how the (un)popularity of stocks influences the liquidity of their options. As you probably know, there was the big scandal in the company Equifax (I also sold some options there). Before the announcement that hackers stole millions of data from the company, the Equifax options were relatively non-liquid. That means if we sold an option for example for 80$, to buy it immediately back, we would have to easily pay $150. Such large was the gap between bid and ask price.
However, as Equifax began to appear in the news every day and the stock price plummeted, the stock options became over time very liquid. The big moves in the price fostered the demand for options as well as they attracted many speculators. As a result, when the situation calmed down few days after the decline, you could sell an option for $80 and buy it back immediately for around $85. One do not want to buy it back immediately. This is just to illustrate how small the spread became.
Looking at the futures options, you will also find different degrees of liquidity. Firstly, there are very liquid options such as in the crude oil, gold or wheat markets. Secondly, there are less liquid options, but still very well worth for trading, for example options on soybean meal, lean hogs or sugar. Thirdly, there are generally non-liquid markets were you better do not sell options, only in the rare case when there is a sudden and unusual liquidity. Those markets are for example gasoline, lumber or orange juice.
Liquidity will save the day
Last but not least, I want to name one last reason why liquidity is extremely important. If nothing else, this is the part which is to be remembered from this post. Once the price of the underlying (where you sold the option) jumps against you, the spread between ask and bid price will get much wider. Actually, it will get unreasonably wide.
This might be still relatively fine, if you sold the option in a liquid market. However, if you sold a put option on orange juice and the price of orange juice futures fell 5% within one day, you might have quite a problem. First of all, you might find yourself in a situation where you will not find any buyer, so you are stuck with the loss or if you find a buyer (the market-maker), he will offer you a completely ridiculous price. The best solution is to wait until the situation calms down and don’t sell options in orange juice anymore. By the way, the same can happen in an non-liquid stock.
Good liquidity can be found in futures as well as in stock options
As a conclusion, I would like to add that this post does not aim to scare you away from options. If you know what to do, there is far less risk that the general public thinks there is in selling options. With a little bit of knowledge, you will easily find the markets suitable for options selling. In addition, suitable money management will substantially decrease the risk.
There is no clear winner regarding the liquidity in futures options or stock options. If you write options on American stocks, in particular, on the very well-known names such as Facebook, Apple, etc. you will find very good liquidity. The same applies for futures markets, for example for crude oil, gold or US treasury bonds. In both cases, you will also find a number of underlying with very small liquidity and those are definitely not the best choice for options selling.