Liquidity and open interest are important for any financial instrument, but for options, it is even more important.
The US stock market is great for working with options. Thousands of securities are available with a fair amount of liquidity.
Liquidity is one of the most important aspects to consider when choosing an option.
The liquidity, in fact, determines above all the costs of entry and exit.
The less the option is liquid and the higher the spread paid.
Many times the spread of some options is more than 10 times higher than the cost of commissions.
Furthermore, when the option is not liquid we will not be able to enter or exit the position.
Not being able to get out of a position will create huge margin problems or make it impossible to stop a losing position.
Generally, when you move away from the strike at the money the volumes are lowered until they disappear.
In these cases, the game is all in the hands of the market maker and is never a good condition.
The Open Interest
To assess the liquidity of an option we will, first of all, examine the open interest.
The open interest represents the number of derivative contracts not yet closed.
The open interest is, therefore, the sum of all the long or short positions opened in the market and at a given time.
While the open interest gives us an idea of the more liquid strikes, the spread tells us how liquid the option contract we have chosen when we want to enter the market.
It could also happen that there is a high open interest but a high spread anyway, so it is always correct to take both values into consideration.
Of course, liquidity will be even more important if we are building a multi-legged strategy.
Even a simple Vertical Spread, even if composed of only two legs, will become a nightmare in the absence of liquidity.
Imagine what could happen if you wanted to open an Iron Condor.
Instead, buying individual options will make it easier to get in the middle and somehow be taken out of the market.
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More Resources: Wikipedia