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What's the Takeaway From the Recent Options Volume Surge? You Still Have to Do Your Homework!
Traders Magazine Online News, March 9, 2018
For the first two months of 2018, OCC, the world's largest equity derivatives clearing organization, has seen the number of contracts it has cleared increase markedly compared with a year ago. In January, total cleared options and futures volume rose 41.8 percent to almost 480 million contracts, while in February, total cleared volume was up 43.2 percent to nearly 478 million contracts.
So what does this tell us?
A number of factors were said to have had a role, including greater hedging in certain contracts, trading strategies being deployed ahead of corporate earnings, and activity that continued to be driven by the new tax legislation.
While all of that may be true, additional context is still needed, as it always is when we see large numbers and records made in the markets. Although volume has climbed compared to 2017, ample liquidity shouldn't be viewed as just a measure of your ability to get in and out of underlying positions. It's also an indicator of market efficiency, showing that you may be able to put your capital to use more productively.
This is important for every investor to understand. We could have significant trading volume, but if the bid/ask spreads are wide or a substantial number of options are trading at a time when the underlying security isn't as active, as an investor you should dig deeper to make sure market behavior is genuinely aligning with your investing philosophy and goals.
But let's start by defining and measuring liquidity. For an option to be appropriately classified as "liquid," we want to see high open interest over multiple strikes. Additionally, bid/ask spreads need to be tight, which means you have greater ability to get in or out of positions at your preferred price. Finally, look for underlying securities that have multiple expirations, such as monthly and weekly cycles, getting interest from investors.
The point is that volume data, while notable, is nothing more than a barren island when viewed on its own. When we instead look at open interest - the open contracts for options - we can see much more clearly if the volume is isolated to one individual strike that's at-the-money or spread across multiple strike prices. A significant distribution shows that there are numerous opinions, therefore providing you with greater ability to make moves and adjustments.
Next, let's consider the context provided by the spread between the bid and the ask. Every time you hit a bid or an ask for a transaction, you are inevitably giving up the edge. For example, if the bid/ask spread on an at-the-money ETF option is two cents, and you buy on the ask or sell at the bid, it will cost you $2 in premium. But if you were trading a high-flyer stock (high priced/expensive), with a bid/ask spread on the option of $3.60, that will cost another $360 if you're buying on the ask or selling at the bid.
The more liquid the underlying stock, the tighter the bid/ask spreads tend to be, which improves your ability to get the price you are seeking, or at least to get closer to it. If there's a shift to lower liquidity, the bid/ask spread will expand substantially.
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