What Is an Illiquid Option?
Because of this, holders of these options may not be able to dispose of them at a fair price in the market and may be forced to hold on to their contracts until they expire.
- Illiquid options cannot be easily or quickly sold or converted to cash.
- Liquidity refers to how easy it is to sell an asset for cash at prevailing market prices.
- Illiquid options have very low or no open interest and therefore may be best held until expiration.
Understanding 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.
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.
Daily volume and open interest should be considered on a relative basis, compared to that of other listed options contracts.
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 on 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.