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.
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.
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.
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 levelling off, but still climbing.
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!
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