How Does Liquidity Affects Options Return

[ironchef]

Let me bring up another topic on options trading.

I saw studies that said illiquidity increased returns for both stocks and options. The authors called them illiquidity premium similar to risk premium.

On the other hand many of you advised new traders to trade liquid index options only, to reduce bid/ask spread, easier to enter and exit, less possibility for manipulation, no earning surprises/gap up-down....

Me, I suspect institutions, professionals don't trade low volume (illiquid) options because they need large volume to move the needle. So, we new kids would be competing with pros and institutions as counter parties if we trade index options. How do we gain an upper hand or are we the one providing them their profits in a zero sum situation?

Any thoughts?

 

[rmorse]

If you trade options with wide spreads and little liquidity, it will absolutely have a cost to doing business that will decrease your returns unless your expectation of gains is much higher than liquid options. You need to make up that cost with larger gains, not a higher frequency of gains.

 

[Martinghoul]

Illiquidity is always a double-edge sword. It can be a source of return, but, obviously at the expense of incurring additional risk. Other than that, it's impossible to generalize and you have to look at the specifics of each particular case.

 

[ironchef]

If you trade options with wide spreads and little liquidity, it will absolutely have a cost to doing business that will decrease your returns unless your expectation of gains is much higher than liquid options. You need to make up that cost with larger gains, not a higher frequency of gains.

So, I need to know what value I should pay otherwise bid/ask spread will eat me up.

A different question, can I assume that the mid point between bid/ask represent "fair value"?

Thanks.

 

[rmorse]

A different question, can I assume that the mid point between bid/ask represent "fair value"?

Not always true. If there are no customer orders and the options in ATM or OTM, it should be close. Customer bids/offers will change the mid point from the MMs. If you want to assume that the MM midpoint is fair value, that can be a good or bad assumption to make. Ether way, it is a good starting point.

 

[Martinghoul]

A different question, can I assume that the mid point between bid/ask represent "fair value"?

Thanks.

You can assume that the mid is the mkt's current best estimate of "fair value", with all the caveats that apply to the latter.

 

[OptionGuru]

So, I need to know what value I should pay otherwise bid/ask spread will eat me up.

A different question, can I assume that the mid point between bid/ask represent "fair value"?

Thanks.

How you think the underlying will trade in the future will determine "Fair Value" and the option trade you enter.

 

[ironchef]

Not always true. If there are no customer orders and the options in ATM or OTM, it should be close. Customer bids/offers will change the mid point from the MMs. If you want to assume that the MM midpoint is fair value, that can be a good or bad assumption to make. Ether way, it is a good starting point.

Yes, I noticed. Usually there were no trades but there were bid/ask with wide spread. When I sell, as soon as I put in my ask price at mid point, the screen immediately showed my ask became the new ask. Often I could sell at that price but quite a few times I had to lower it again to get sold.

 

[ironchef]

How you think the underlying will trade in the future will determine "Fair Value" and the option trade you enter.

How I think the underlying will trade is not the "fair value", it is my wishful thinking.

Just kidding but thanks for your input.

 

[Sig]

So, I need to know what value I should pay otherwise bid/ask spread will eat me up.

A different question, can I assume that the mid point between bid/ask represent "fair value"?

Thanks.

You can also look at the mid of the surrounding options and use their IV to back into the correct mid for your option if a stubborn limit order on one or both sides is blocking the true mid of your specific option. If you're doing spreads you can also look at the opposite option for the same spread and subtract from the spread amount, e.x. if you have a 100/105 put spread look at the 100/105 call spread, flip the sign, and subtract it from 5 to get the implied put mid. At least on spreads I often can tell that a limit order is interfering with the true mid just by watching the tape on liquid options. The bid/ask are usually always jittering back and forth a few cents/nickles so if one side is steady it usually indicates a limit and you have to assume the true edge is somewhere further out, i.e. the true mid is closer to the steady side than the current arithmetic middle.