Why I care about Liquidity

Liquidity is how easily an investor can buy or sell an asset without losing much value. The more an asset is traded, the more liquid it becomes.

I only trade liquid products. As a self directed investor, I want to trade the most efficient option markets. This allows me to get in and out of our trades at a fair price. As long as I stick to the most liquid products, I will consistently maintain the ability to get in and out of trades effeciently and effectively.

Now that we understand the meaning of liquidity, it is important to understand the criteria I look for at order entry in order to decide whether a product is suitable to trade. It is important to assess stock and option volume before placing a trade. Because options are a derivative of stocks, if the stock has low volume, so will the options. In addition, the bid/ask spread will depict how tight the markets are, and represent the prices that a trade can get in and out of the market. Another important reason I trade products with extremely liquid options is that more liquid options have much more accurate probabilities (as calculated by the Black-Scholes pricing model).

How do I determine strike selection?

The first place I start when selecting strikes is to determine the preferred probabilities. The 1 and 2 standard deviation lines are visible on dough to use as a starting point in strike selection. These lines are available in curve and table view as shown here:

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Once probabilities are determined, it is critical to tweak the strikes based on liquidity if the underlying is not extremely liquid.

The bid/ask spreads will often give me a good idea of the liquidity. I also check the volume and open interest. Options with high volume and open interest will often have tight bid/ ask spreads.