#323 - Liquidity Considerations For Closing Option Trades

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Aug 11, 20185m
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#323 - Liquidity Considerations For Closing Option Trades
Aug 11 '185m
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Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we’re going to be talking about liquidity considerations for closing option trades. Again, another question that was sent in from one of our members and he basically said, “If I decide to close out a position and there's no liquidity, does that mean that I'm stuck with the options or does it simply mean that I can sell back or buy back for a lesser or worse price?” This is a great question because what we talk about often with options trading is that liquidity should be one of the things that you look at on a consistent basis, that you can use our watch list and toolbox software, in which case, we screen and kind of filter out tickers for liquidity already for you. We try to close that gap and remove that barrier immediately. But if you are going to trade say a random stock or a random ETF, you should be looking at the liquidity. We've done shows on this that you can search in the podcast app or on our website about liquidity requirements. But liquidity is so important not only just because you should be trying to trade something that's liquid where the pricing seems to fit and there's a lot of action in it, but because it allows you the flexibility to get in and out of the contracts very quickly. When you have no liquidity and in this case, this guy was asking when there's no liquidity. No liquidity could be just under maybe 100 contracts of open interest, maybe one or two contracts a day. It does leave you with two choices. The first choice of course is you can stick with the contract and go through the expiration cycle. Now, that of course is up to you, it’s up to your account, but it also means you’re going to incur a lot of higher commissions because closing out an option contract might cost you $.75 in commissions, going through the exercise process might be $12, $15, $20 as some brokers charge a lot of money to go through the exercise and assignment process.

If you do get stuck with the option contracts which you can do, you can go through that process, but in many cases, you don't want to do that and so then, your second choice is, “Well, how do I close?” Well, if there's no liquidity there, then what you have to do is you have to reduce or increase your price to entice someone to take on enough risk that compensates them for the lack of liquidity. It’s very much like real estate. I think real estate is a great analogy for this because if you're trying to buy a piece of land in the middle of nowhere that nobody really wants, that no utilities are connected to, it's probably not that expensive because a land has to be cheap enough to entice somebody to want to come there for whatever reason and to overcome enough risk to be out that far from civilization, to potentially have no electricity, no water, no conveniences around, no Targets or anything around you. And so, the price has to be low enough to entice people to come there. And so, that lack of liquidity means that something has to give and usually, it's price. In the case of option contracts, when you're trying to buy back a contract if you’re short before, you might have to buy back that contract for a much, much higher price which reduces the potential profit that you have if you have a profit and that slippage can really, really hurt over time because you don't know what that threshold is. Maybe you have to buy it back for $50 higher than what it says it could be traded for right now and that slippage could be really, really damaging. I think that you have to really look at liquidity as a big means for deciding whether to get into contracts or not.

What I found over just the last say four or five years is that as we start to scale up and our portfolio size starts to grow, I'm really concerned more so now than I was before about liquidity and I’m even forward-looking and saying, “Okay. If my portfolio was three or five times higher than it is right now, how does this change what I would be trading right now? Should I be trading the same products that have the scalability on the liquidity side to handle many, many more contracts?” And if you're looking at something and there's not enough liquidity, it's not worth it. It's just really not because as much as that trade maybe looks like an amazing setup, an amazing trading opportunity, the liquidity really reduces that profit gap and could actually lead you to making a losing trade when you should have made a winning trade. As always, hopefully this helps out. If you guys have any questions, let me know and until next time, happy trading.

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