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Trading Strategies

How to Measure Options Liquidity

Before we even think about thinking about how to measure options liquidity, we need to talk about what option liquidity is. Liquidity is a term traders love to throw around, but SO MANY traders don’t fully grasp the concept. They look up online how to measure it and often get some bad guidance that doesn’t help at all. Here’s the skinny on what options liquidity actually is.

What Is Options Liquidity?

Simply put, liquidity is how much buying or selling pressure an option can absorb without changing the price. (And if you’re a person who likes to reference definitions, keep a link to this handy. The stuff that comes up online when you google it ranges from convoluted to just plain wrong.)

Say you’re looking at this market here…

…liquidity means (in its purest definition), “Can I buy the number of calls I want at the current offer price of 3.40?”

How to Measure Options Liquidity

There’s really an easy answer to that most basic question of liquidity: Look at the size of the offer. See here…

I always have the “Size” column in my option chain for that reason. The “243” is how many calls are bid at 3.25 and the “6” is how many are offered at 3.40. So, if you want to buy 6 or fewer calls at 3.40, you can. If you want to buy more than 6, you can’t.

Now that is actually a bit of an oversimplification. And it doesn’t really get to the heart of some other questions we may have on the topic. Firstly, if you try to buy 7 calls at 3.40, the fact is, most of the time, you’re going to get filled. That’s because in the poker game that is option trading, the liquidity providers (a.k.a. market makers) don’t want to show their hands. They program their quote disseminating machines to generate bids and offers and show a size they are willing to buy or sell there; but there’s also “the real market,” which is usually tighter and in greater size (deeper).

So, another reason we talk about liquidity is to develop expectations as to how likely we are to get filled at a better price by “middling the market”—meaning trade somewhere between the bid and the ask—essentially finding the “real” bid and/or offer. So how do we extract that information from the data that are available?

First, it’s important to understand what goes into how those markets are made. And there’s a lot to it. An old colleague of mine used to say, “Hotdogs, laws and options markets: You don’t want to see how any of those things are made!”

But a lot has to do with the likelihood of the market maker to be able to “get out” of the trade, once he or she gets into it because, remember, they are buying the bid and selling the offer. They basically have to wait for someone to come into the market and hit their bid or take their offer. The don’t act; they react. That’s why they like to keep the size they show to the public small. If they take on enough risk by selling at 3.40, they want to be able to raise their bid (to attract sellers so they can buy them back more easily) and their offer (so if they take on more risk by selling more of those calls, they are compensated more for the added risk).

That said, the more trading that happens in a particular class of options (meaning options listed on the same stock), the bigger market makers are willing to trade and the more likely they are to cut their markets and trade between their disseminated bid-ask spread. So, how do we know how much trading goes on in a stock’s options? Look at volume and open interest.

How to Use Volume and Open Interest

Volume is the number of contracts that has traded thus far today. It starts at zero every day and goes up as more trades occur (buys or sells). Open interest is the number of contracts that have been opened. So, if that option has never traded before and someone buys 10 (from the market maker) volume is 10 and open interest is now 10. But if someone else later that day sells, say, 2 of them to the same market maker (who is short the 10 he sold earlier) volume goes up to 12, but open interest stays at 10, because the market maker just bought them from someone else who is now short them—10 still exist. (It’s tricky. But if you just keep in mind open interest is how many options exist right now, you’ll do fine.)

I also like to keep volume and open interest in my option chain. See the more expanded version of this option’s data here…

As we can see, 217 of these traded today. To date, 638 have been created. That’s not a ton; but it’s a fair amount. If these numbers were close to zero, the real markets would be wide and not very “deep”—meaning not a lot on the bid or offer. If these numbers are in the thousands, it’s likely you’ll be able to buy or sell a lot more than what is shown and probably buy a little lower than the disseminated offer (or sell a little above the bid)—i.e., the real market is deeper and tighter.

It’s important to note volume and open interest are not the same as liquidity. They are a way to infer information about liquidity. Sort of like looking at the weather app instead of just walking outside to see how the temperature feels. But between looking at the disseminated width and size, and then the volume and open interest figures, you should have a great way to make realistic assumptions on your likelihood of what price you can get filled.

Trade Smart,

Dan 

Dan Passarelli
Founder and President
Market Taker Mentoring

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Trading Strategies

Be on the Side of the Market

If you know anything about me, you know how much I look for support and resistance areas on charts to help give me an edge. Just recently, the S&P 500 ETF (SPY) was challenging a resistance level. The market had rallied at the beginning of November, and around mid-month the SPY was trying to move above the $400 level. Round numbers often act as support and resistance levels on charts. As I often remind traders, ask yourself, “what has a better chance of happening?”

Let’s Take a Closer Look

As you can see from the chart below of the SPY, the $400 level was threatened in three consecutive sessions. If you play the odds, you know the ETF had a better chance of not breaking through that level immediately just like what happened. In group coaching class I reminded everyone to watch and be patient and let the underlying prove it wanted to continue to move higher because the odds were not on the side of a break at that level.

market

How to Use This Info

As I often say, just because the market is moving higher does not mean the underlying you are watching or trading is necessarily doing the same and vice versa. But generally, stocks rise when the market rises and fall when the market drops. When the SPY was testing resistance at $400, was this the best time to get a bullish market on your side? The answer is no. The ETF and the index had a better chance of stalling out like it did for three sessions than moving higher. Be on the side of the market!

Improving the Odds

When looking at charts and seeing support and resistance levels, just know that the underlying has a better chance of not breaking through that level. In my opinion, it has at least a 70% chance of not doing so. If you are looking at a potential trade, this knowledge can improve the odds considerably.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring

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Trading Strategies

Basic Options Strategy (and More)

I was sitting on a plane to Vegas earlier this week thinking about what is most important for option traders, and I ended up having one of those moments of clarity. The best basic options strategy is to follow the rules (see side note at bottom).

Basic Strategy in Blackjack

If you play blackjack and don’t get totally cleaned out every time, one of the things you probably incorporate into your playing is what is simply called “basic strategy.” Blackjack basic strategy is this pretty brilliant matrix someone figured out one day that says basically (see what I did there, “basically”? Ha!) if your cards have X point value and the dealer’s face-up card is Y then do “this” (“this” being hit, stay, split or double).

Yeah. Someone actually sat down and figured out the math to see what is statistically the superior move given every permutation of hands that can be dealt. If you think about it, it’s not a real monumental feat because the player’s (your) cards can only add up to a value from 2 to 21 and the dealer can only show a card that is 2 through ace. So, it’s not a massive number of permutations really.

To be fair, even if you play basic strategy, you’re still at a disadvantage because you give up a small edge to the house, but you’re sacrificing way less edge than those random, wild gamblers who don’t use it. To have a true edge over the house, which IS POSSIBLE, you also need a betting strategy and a card counting system (which is NOT illegal; it’s just, “frowned upon” by the casinos, which will have their, umm, nice security people kindly escort you off the premises—best-case scenario). But in a nutshell, that’s how you win at blackjack.

Well, guess what? Options trading pretty much works the same way.

Basic Options Strategy and Getting Edge

If you’ve been with the Market Taker Family for a long time, you’ve heard both John and I harp on having a plan and setting your exit strategy at the time you enter the trade. If you’re new to the Market Taker Family, well, you’re about to hear John and me harp on about having a plan and setting exits for the foreseeable future. (You’ll thank us later. Right, older MTM generation?) Rounding out our analogy, it basically goes like this…

We don’t really separate out the basic strategy from the edge with trading. They end up being one and the same. So, there’s the slight difference. Reason being, no one has ever done some sort of decisive, universal, statistical analysis based on a fixed number of permutations. That’s because, well, unfortunately, there’s not a simple fixed number of permutations in trading, especially option trading.

This endeavor becomes the job of the trader—to create a set of if-then rules that should yield a profit if traded over and over again. To create a basic strategy of sorts designed to give edge so you have a greater likelihood of making money with a focus on the combination of odds of success and the risk-reward ratio. (That’s your job. It’s John’s and my job to do a lot of that work for you and make this task easier for you.) Let’s look at how this works in real life.

How to Get Edge on Put Credit Spreads

Let’s talk put credit spreads for this example. We would logically put them on when we think a stock is not going below the short strike price. But why? Is it because we hope it’ll go up, akin to the novice blackjack player who hopes he’ll get less than a 3 so his 18 gets closer to 21 even though the dealer has a 6 showing? No. It’s because we have some edge-building reason for making the trade.

One of those edge-building reasons could be that there is support at or below the short strike level. The existence of stock support changes the pure randomness of the assumed lognormal distribution stocks supposedly adhere to. That’s because support (or resistance for that matter) has a somewhat better chance of holding than not. So in placing your short strike at or below support, guess what? You just gave yourself an edge.

Another is that we avoid selling spreads “too cheap.” At MTM we have the 10% Rule that states you should never sell a credit spread for less than 10% of the strike width. This rule is rooted in some mathematical / statistical discoveries about the stock market that actually have been done.

Stock price distribution is leptokurtic, meaning its probability distribution has “fat tails.” Still need plain English? Big unexpected moves happen more often than normal statistics say they should. Fat tails throw off the probability-vs.-risk-reward nature of these trades, rendering selling credit spreads too far from the money—and consequently too cheap—a bad play.

Edge-Based Trading Systems (What They Can and Can’t Do)

Many of you subscribe to the Credit Spread Genius system I created. (If not, here’s a link to a recording of the training in which I explain how it works. To clear up any misunderstanding of the system, the “trade trigger” component is a small part of the edge. Those trades that pop up are made by the “smart money,” so there’s an assumption they might be good.

But a lot of the edge comes from simply following the basic strategy laid out in the coursework. The edge builders in that system are both on the setup (like support and resistance and the 10% rule) as well as the risk management (like being conservative and closing the spreads long before expiration to take profits, and taking a loss or adjusting if the stock goes through the short strike).  

Edge-based trading systems don’t aim to predict anything. They make things more likely, give better risk reward, or both. They create a system in which if you play that specific opportunity by those specific rules enough times, you make money.

As for My Side Note…

I arrived on this topic because I booked my flight to Vegas at the last minute and ended up with a middle seat. The guy in the aisle seat insisted on resting his elbow on the armrest between us. This is a clear violation of the unspoken “gentlemen’s agreement” that the middle seat passenger gets the armrest. Window seat gets the nice view and head rest, aisle seat gets the uncrowdedness and ease of getting up to go to the restroom, and the middle seat gets the armrests. Any experienced traveler knows this. I would have assumed this guy was not an experienced traveler and been more forgiving, but he had some pro-tip travel gear conveniences. AND we were seated in “Poor-Man’s First Class,” the exit row, which experienced travelers know gives you extra leg room. To boot, we were in the back-most exit row of the two over the wing—the one where the seats recline unlike the front one. (To be clear, we’re talking row 21 on a 737 on United flights.) So, obviously, he knew the rules but chose to violate them. Do you believe this guy? So, yeah. Rules, man. They are important.

Dan Passarelli
Founder and President
Market Taker Mentoring

 

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Trading Strategies

A Credit Spread on CRM

When looking at a chart, I often tell my group coaching students to ask themselves what has a better chance of happening. What I mean by this is that if there is any potential support or resistance, a trader can use it as a proxy for what is more likely to happen. In short, support and resistance have a better chance to keep the underlying from moving through that level. Let’s look at a recent trade idea on Salesforce Inc. (CRM) that we considered in class.

Interpreting CRM’s Daily Chart

Using the daily chart of CRM below, we saw that the stock gapped higher at the open and continued to move higher for a time. We spotted the 50-day moving average and horizontal potential resistance around the $160 level. That means we noted two potential resistance levels that should keep the stock from moving through the level based on percentages.

We looked at a high probability trade idea, which in this case was a bear call spread. With the stock trading around $154.45, we modeled out the Oct-21 (less than 4 days until expiration) 160/162.5 vertical call spread for a credit of 0.45 (using the mid-price) as seen below. The 0.45 ($45 in real terms) would have been realized if the calls expired worthless at expiration. The total risk on the trade idea was 2.05 (2.50 – 0.45) or $205 in real terms. The position had a negative delta of 0.08 and a positive theta of 0.09 at the time. A move lower in CRM would result in the call premium decreasing, and time passing with positive theta on the position was beneficial as well.

Profits Can Come Swiftly

As the day progressed, CRM drifted a little lower (about $153.32 at the time). The call premium shrank and time passing reduced the mid-price to 0.30 as seen below. Based on the mid-prices, the position decreased in value by 33% ((0.45 – 0.30)/0.45). Not too bad for less than a day passing. Of course, returns of that nature cannot always be expected, but they often do happen.

Odds and Cooperation

Looking back at this trade idea, the odds were on the side of profit with three out of four ways to profit. The stock could have moved a little higher as long as it stayed below the breakeven level by expiration, it could have traded sideways, or it could have moved lower at expiration. However, those great odds came with more risk as noted above. What also helped this position sooner than later was the negative delta decreasing the call premium when the stock moved lower in the day. What has a better chance of happening? You need to be able to answer that question to give yourself even better odds as an option trader.

 

John Kmiecik
Senior Options Instructor
Market Taker Mentoring

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