Do Liquidity and Open Interest Matter?
How can I be sure that I can sell my DITM options? Can you show me some proof that you’ve done that? What if I’m stuck with them? What if no-one will buy them?
I’ve been getting a lot of questions like this recently. It’s understandable; the market has been skittish, and people are worrying and preparing to dump their positions.
Most of the questions relate to the fact that on most DITM options there is low open interest (OI) – but low OI doesn’t necessarily mean that there is low liquidity.
Liquidity refers to the ease with which you can buy or sell options.
Open interest is the total number of outstanding options contracts for a particular strike and expiration date.
The two are often lumped together and taken to mean that low OI means low liquidity, and the corollary often drawn is that if there is low OI then you won’t be able to sell your options. This may have been true before 1973, but it isn’t true now. When CBOE set up the options market, it included these wonderful things called market makers.
Designated Market Makers
Designated Market Makers (DMMs) have very specific obligations about providing liquidity by having a continuous bid /ask, If we look at the options chain for SPY DITM options we can see that at the $225 strike there is zero OI but there is still a bid / ask and the spread is practically the same.
The spread is simply the difference between the bid and the ask; this is also regulated. Why is the spread important? Because if it is large then you may be buying too high or selling too low. Market makers and have to make sure that the spread is narrow enough for fair pricing. Spreads tend to be larger in thinly-traded tocks. Here is a comparison between the most highly traded (SPY) and the most thinly traded (CAR (Avis):
In short, by providing liquidity the market makers ensure that there is ALWAYS a bid / ask, and so you can be sure of selling your DITM options.
No Bid / Ask?
It won’t happen on the NYSE, but it can happen on other exchanges. I have traded in markets where there is no bid / ask, as in the chain was showing all zeroes. At first glance it looks as though you cant trade anything, but there is a way. The market makers are there, the just don’t provide a continuous bid/ask, hence the zeroes. I have included a section in the Bull ITM book, Chapter 8, called ‘Teasing the Market Makers’ to show how you can still trade in such a market. But that doesn’t happen on the NYSE.
The Madness of Crowds
I know a lot of books stress the importance of having a high OI, but all I would like to say is:
If you are wrong you are wrong; it doesn’t matter how many people agree with you.
If you haven’t read the book, Extraordinary Popular Delusions and the Madness of Crowds, by Charles Mackay, you might like to.
From tulipmania, to witch hunts, to the philosophers stone, you can see how humans go mad in crowds, but come to their senses one by one.
Sell In May and Go Away
So how would this have worked out for you?
1 May: SPY $415.51
1 September: SPY $451.19
So – not wonderful advice.
Shut Down Averted
Another thing making the market skittish was the threat of a government shutdown, which over the weekend was averted. That’s the good news. The bad news? We’ll have to go through the whole shenanigans again when the money runs out on 3rd December.
SPY Chart
Another dismal week. SPY dropped below resistance at $430, but didn’t / hasn’t dropped to the next support level at $418. We are not yet at a death cross, but we are getting closer, approximately 14 points away.
However, there is one encouraging sign – the pink rectangle is showing an almost perfect bottom reversal pattern, the ‘morning star’. Clutching at straws? Possibly! I’ve taken the chart back until the start of 2023, and also put on the volume, so we can get things in perspective.
SPYG Chart
As for SPY, SPYG dropped through resistance, and the 10 SMA and 200 SMA are converging. On the bright side, it also has a morning star candlestick pattern.
QQQ Chart
Although we don’t trade it, we keep a eye on it The QQQ chart looks better – although it dropped below support it is not back over it, and it also has a morning star pattern.
VIX Chart
VIX levelling off, but still climbing.
ITMeter
Daytrading Experiment
I can honestly say I am right over it. I hate losing money, and I am now down around 20% since I started in April. It’s a small account so I am not worried about the money – just the effect it was having on my psyche. Sitting down to follow someone into a trade that your mind was screaming at you not to take? Very uncomfortable, and not enjoyable.
Here are his interim results for September. As I said in my last blog post, all it seems to need for a gun trader to turn into a losing trader is for me to follow them! Happens so many times.
The week ahead
Next week, we will look at finding options to fit the ITM strategy. In the meantime, please feel free to ask any questions in the comments section below, I usually get back within a day.
At time of writing, the futures are up nicely. Perhaps we are in for a good week – goodness knows, we deserve one!
Heather
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14 thoughts on “Liquidity and Open Interest”
Hi Heather,
Thank you for your wonderful weekly thoughts of the stock market. I just want to drop by and say hi to you and others in here. Please be well, do good works, and keep in touch.
Sincerely,
George Halongton
Hey George,
how perfectly lovely of you to take the time to do this. Thank you so much!!
x
h
Re-enter when price action warrants and 10/50 sma is positive again.
Simply use the 10/200 sma for entries, and
use the 10/50 sma for exits.
When and if whipsaws occur, trade accordingly.
Its just the ‘when price action warrants’ I want to pin down, and ‘whipsaws’.
Yes, I get the 10/200 for entries, and the 10/50 for exits – but when you get out on a 10/50 death cross, when do you get back in again it the 10/200 is still positive?
h
The so-called Golden Cross (traditionally 50/200 sma, or your version 10/200 sma) work well for entries since both, especially the traditional, demonstrate a strong trend. But using a Death Cross (10/200 or 50/200 sma) for exits begs the question. Why? Why can’t a different moving average be used?
Just because those moving averages work well for entries, doesn’t mean they work just as well for exits. Personally I use the 10/50 sma for exits.
Protecting profits is one of the most important lessons in trading. Why give back a substantial gain?
Your DITM strategy is excellent. I like your weekly comments and charts very much. I have purchased both your books. I’ve written a very positive review for you on Amazon. Keep up the good work.
Michael
Hey Michael
there’s no reason a different MA can’t be used – I was trying to keep things simple, as long as they were effective. But funny you should say that – I have had quite a few emails from people asking similar questions – and I have decided to build myself a nice new system to make backtesting my ideas, and finding new ones, easier. So I have started, and I hope that refining the exact parameters, plus checking which indicators I use, so much easier.
I have looked at exiting on the 10/50 chart, and agree that it would have worked well this year in getting you out. But when do you get back into a trade? It can’t be the 10/200 cross because that is showing bullish while the 10/50 is showing bearish.
Let us know, all ideas and experiences welcome. Learning is good for us!
h
P.S. thank you for the review – it is really appreciated!
Message: Hi Heather ,
Just wanted to say I really enjoyed your books.
Still working through using them and setting up how to do it within my circumstance. The 7 step plan is simple but I have been not in action.
I believe you are potentially in West Australia from the ITM book as I am.
I was wondering do you use a particular broker from Australia or recommendations for this ? The ITM book pg 210 suggests the broker recommendation is on the website but I have not found it. I have joined Saxo and my apologies if you have addressed this question in a blog previously.
Cheers
Dan
Hi Dan,
yes, I am in WA! Nice to hear from a reader here too! Most of my books are sold in the US and Europe – the Australian sales are pretty low, so I had rather given up on them.
The list of brokers is actually still there – I removed the link as I thought no-one was interested. Here it is:
https://heathercullen.com/australian%20edition/
I have accounts in Australia, but I don’t trade the US from them.
I have accounts at Saxo, Charles Schwab and Firstrade – Firstrade is no-frills, which was fine a few years ago as they were one of the first to introduce zero brokerage. Now others do, so you could look for more functionality. Saxo are OK, but I don’t get a warm fuzzy feeling from them – I find their website very annoying. I have a couple of accounts at Charles Schwab (one retirement, one personal) and I find them the best. Their platform SSE is excellent, very comprehensive and intuitive.
(P.S. Ive closed my accounts with Interactive Brokers – IMHO they were terrible!)
Maybe I should put the link back on again. OK, will do.
Hope this helps.
h
Hi Heather,
Thanks for your quick response. I’m definitely looking forward to the backtest data.
I have a follow-up question. I know you’re not a financial advisor and I understand that you couldn’t possibly advise on anyone’s individual financial situation. So, I’ll still ask the question but would understand if you didn’t feel comfortable answering.
Assuming you were already retired and also withdrawing funds from your account for your living expenses, what withdrawal rate would you recommend? My best guess is that assuming you used 50% leverage and were able to 2x the index you could comfortably withdraw 8% or 2x the standard 4% rule.
Hi Ankur – effectively I have already ‘retired’ as I closed my business down 6 years ago, and have been living off my investment earnings. I can’t recommend what to do in your case, I can just say what I do. As long as my net worth (ex house) is going up then I withdraw what I like. I holiday in Europe for 3 – 4 months every year, have a cleaner and a gardener, plus I have recently bought a new house, with a fabulous view, so am looking forward to living there. Basically I have a nice life that I really enjoy, but I am not a complete spendthrift! (apart from travelling, I suppose). I don’t buy a lot of ‘things’ just for the sake of having them.
But that doesn’t help you really – I just look at my bottom line (i.e. net worth), and if after I have taken out the money I need it is still going up then I am happy – not terribly scientific I’m afraid!
Sorry cant be more helpful!
h
the 4300 level is important. it has been tested and the ITM strategy still shows a gain.
ron
Hi Ronald
Yes, we have definitel broken that support level. Yesterday was not pretty – to be expected I suppose with the political turmoil. But the 10 SMA has been trending down for most of September and we are possibly approaching a death cross. I hope not, but the next support level for SPX is 417 and if we get there then it is our OUT signal (as it is below the 200 SMA).
Dammit, why can’t the market just be nice and behave? It makes everyone happier!!
h
Heather,
I’ve read both the ITM Bull and Bear market strategy books and I thought they were both excellent. I actually came up with a similar strategy prior to reading your books. However, I was more aggressive and bought SPY LEAPS with deltas ranging from 0.65 – 0.80. Thus, I know from personal experience that your back-tested results are impressive and possibly even conservative.
After reading Meb Faber’s Ivy Portfolio, I was using his simple timing method of the 10-month moving average and month-end prices. However, I much prefer your moving average crossover system.
In the Bear Market book, you mentioned that combining the moving average crossover with +/- reading of .50 on the MACD could help with accuracy. Given we’re so close to a Death Cross, waiting for confirmation from the MACD histogram makes sense to me.
Have you done any backtests or plan to do any using a combination of the moving average crossover and MACD? I would love to see the results.
Hey Ankur – thank you for your kind words – you have no idea how much they are appreciated.
And funny that you should ask about more backtests – I have just started creating a new backtesting system which will be based on SMAs, EMAs, MACD (which is essentially 3 SMAs) and including volume. I haven’t given myself a deadline for completion, and I expect there will always be room for extra ideas in it, but expecting in the next month to have a working system.
So, yes, it has been on my mind for a while, and I will definitely do it.
x
h
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