What Is an Illiquid Option?
An illiquid option is a contract that cannot be easily sold or converted to cash quickly at the prevailing market price. Illiquid options have very low or no open interest.
The Basics of Illiquid Options
Liquidity is the degree to which an asset can be quickly purchased or sold on the market. An option is a versatile security. Traders buy options to speculate on their current holdings. Stock options will normally represent 100 shares. Options typically trade less frequently than their underlying assets, such as stocks or bonds.
An illiquid option has a very low level of liquidity. The liquidity of options is much different than those of stocks. The liquidity of stocks is typically judged by the stocks' daily trading volume, whereas options are not necessarily traded as heavily. In fact, there can be hundreds of different contracts for options available on the market.
Most options are illiquid when they are far away from their expiration dates. If you're holding an illiquid option, you will usually notice a very large bid-ask spread on the contract. This is because there are not enough buyers – and therefore, not enough interest generated – to accommodate those wanting to sell.
How to Determine Illiquidity
There are generally two ways in which to determine liquidity for an option. First, is the daily volume, or how many times it was traded that day. The higher the volume, the more liquid it is, while a lower volume will mean a lower level of liquidity.
The second way to determine liquidity is through open interest. The higher the open interest, the more liquid the option will be. However, if there is very little open interest, that option can be deemed illiquid.
Disadvantages of Trading Illiquid Options
If you're going to try to trade illiquid options, you should be aware of the pitfalls of doing so. First of all, because there is a very low level of liquidity, the bid-ask spread will be much wider. That means you'll be relying people in the market who want to hedge their bets in an environment that isn't highly liquid.
Chances are, you may have a difficult time trying to sell an option that is illiquid. If you're lucky enough to do so – if at all – there is a good likelihood that you'll be selling it at a discount instead of the market price – or the price at which you're willing to sell.