Illiquid Securities

Overview

When the options contract cannot be sold or converted to cash promptly at the going market price, we say that the option is illiquid. Options with little or no open interest are considered illiquid.

It’s possible that holders of these options won’t get a good market price for them, meaning they’ll have to sit on their contracts until they expire.

Check out our last article on Illiquidity, its riaks and examples

• Options that are illiquid cannot be sold or converted to cash quickly or easily.
• The liquidity of an asset is measured by how quickly and easily it can be sold for cash at current market pricing.
• Options with very little or no open interest are considered illiquid and may be better off being retained until they expire.

Demystifying “Illiquid Securities/Options”

The term “liquidity” refers to an asset’s ability to be bought and sold swiftly in the market. Options are a very flexible type of investment.

Traders engage in speculative activity by purchasing options. Typically, a stock option will be for a block of 100 shares. Options are traded less often than the equities or bonds that they are based on.

The liquidity of an illiquid option is extremely low. Options have a very different liquidity profile than equities.

Options are not often as actively traded as stocks, although the volume of daily trading is a common measure of stock liquidity. In reality, the market for options can feature hundreds of such contracts.

FACT

When an option’s expiration date is quite far in the future, it may be difficult to sell.

If you own an illiquid option, the bid-ask spread on the contract is likely to be very wide. The reason for this is because the market is unable to support the number of sellers that are now available.

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Methods for Identifying Illiquidity

An option’s liquidity can be assessed in one of two ways. The first metric is the day’s volume, or the total number of trades.

A bigger volume indicates greater liquidity, while a lower volume indicates less so.

Open interest is the alternative measure of liquidity. A higher open interest indicates that the option is more liquid.

On the other hand, an option may be considered illiquid if there is very little open interest.

IMPORTANT

Open interest and daily volume should be evaluated in context with other listed options contracts.

Prons of Dealing with Illiquid Securities

It’s important to know the risks involved if you want to try trading illiquid options. To begin, the bid-ask spread will widen significantly due to the extremely thin market conditions.

If the market isn’t very liquid, you’ll have to rely on those who wish to hedge their bets.

If an option is not actively traded, it may be difficult to sell. In all likelihood, you will have to sell it below the market price, or below the price at which you are willing to sell it, if you are lucky enough to sell it at all.

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