Options Trading Liquidity: Volume, Open Interest, Size & More

What is Liquidity?

The word “liquidity” comes from the Latin liquidus, which means ‘to flow’. In the financial world, liquidity means the ease with which assets can flow from one to another (e.g., stock to cash) with minimal loss of value and without significantly affecting the underlying price. 

Liquidity is essential in options trading. If you don’t understand and master the liquidity metrics discussed in this article, you will inevitably lose money over time when trading options. It’s that simple.

Why is Liquidity Important in Options Trading?

Every single options contract has its own distinct market. Take SPY (SPDR S&P 500 ETF Trust), for example. This ETF has thousands of unique options markets, each defined by dozens of expiration cycles and hundreds of strike prices. 

Here’s what the hierarchy of an options market looks like.👇

Now understand that over 5,000 listed securities in the U.S. offer options. You can imagine there aren’t enough market makers to cover them all efficiently. This is why liquidity is crucial in options trading. 

If you ignore liquidity, you’ll be making constant donations to the Market Makers of America Gibson’s steak dinner fund.

Options Liquidity: Poor Example

For example, let's say you want to buy a LEAP option on SPY. LEAP options have expiration dates more than a year out, so these options typically have very little activity, leading to poor liquidity.

Without checking for liquidity, you send a market buy order for a 750 strike price call option on SPY, expiring two years out, and get filled at $7.

A week later, you need to meet a margin call, so you're forced to sell the option.

But the bid is only $4! Worried, you check the offer price, which is still at $7. This means you would incur a $3 loss immediately—almost half of what you paid for the option!

You check SPY options expiring in 14 days and see the spread is just pennies wide.

So, why is this happening?

Why Liquidity Matters

It’s because no one is trading options that expire in two years—most traders prefer to focus on options closer to the ‘front month.’ Market makers set wide spreads when there’s little competition to provide liquidity that far out. This is due to the difficulty in effectively pricing and hedging options cycles set so far into the future.

Your best bet is to try getting filled at the ‘mid-point,’ which is right in the middle between the bid and ask—$5.50 in this case. Fortunately, you get filled at the midpoint. You still lose $150, while the market maker enjoys a double porterhouse.🥩

Welcome to options trading!

⚠️ Besides the initial premium paid, it is essential to consider the commissions and fees associated with most options transactions when calculating net profit or loss. These fees can significantly impact the overall return on investment and should be factored into all trades placed.

4 Liquidity Metrics for Options Trading

Most beginner options traders, having traded stocks, instinctively know to check the bid/ask spread before placing a trade.

But as we mentioned earlier, there are a lot of options markets. How many? ChatGPT estimates millions. This means we need to broaden our liquidity research when trading options to ensure better decision-making.

Here are the four liquidity metrics you should check off before placing any options trade: 

• Volume - how many options have been traded on any given day?
• Open Interest - how many open positions are there on a particular option?
• Spread - what’s the bid/ask width?
• Size - how many contracts are offered/bid at the specified price?

Perhaps we can remember these liquidity metrics as “VOSS”. If you can think of a better acronym please let me know!

Let’s now explore them one by one. 

📖 Intrinsic and Extrinsic Value in Options Trading

1. Volume

As in stock trading, the volume of all options traded on any given day is visible on most trading platforms, including TradingBlock. In options trading, volume simply refers to the number of contracts that have traded since the market opened for the day. This starts at zero on market open and reaches its peak by market close.

Generally speaking, the nearer an option is to its expiration, the more volume it has. Since volume increases liquidity, we want as much volume as possible.

For example, here are the volumes of SPY options expiring tomorrow on the TradingBlock platform.

That’s a lot of volume. Also, notice that volume increases as the option approaches being “at-the-money.” This happens when the strike price of the call or put option equals the price of the underlying asset, whether it’s a stock, ETF, commodity, or even currency.

Now let’s take a look at some call and put options on SPY that expire in exactly 365 days. Options that expire in more than 1 year are referred to as ‘LEAP’ options.

As we can see, the volume plummets on LEAP SPY options. When you go 2+ years out, it’s not uncommon to see zero volume on most contracts, which should be a huge red flag. 

2. Open Interest

A lot of people confuse volume with open interest. As we learned, volume is the number of contracts traded thus far on any given trading day. 

Open interest, on the other hand, tells us the total number of outstanding contracts that are still active. This means the contracts have yet to be closed, expired, or exercised/assigned. 

Unlike volume, open interest doesn’t reset daily but is updated as contracts are opened or closed. High open interest is synonymous with high liquidity. You want other people trading what you’re trading. More participants mean more market makers are involved, and with more market makers comes greater competition. Greater competition leads to tighter spreads.

3. Spreads

As we learned earlier, the tighter the spread, the more liquid the option. 

In highly traded products like QQQ (Invesco QQQ Trust) and SPY, option spreads can be as tight as $0.01. This means that the bid may be 0.99 and the offer may be 1.00. In other words, if you buy the option for 1 you can immediately turn around and sell it for 0.99, losing only one penny in the process. 

Here are examples of tight spreads in front-month SPY options. Again, notice that the spreads get tighter as the option approaches at-the-money (strike price = stock price). 

As we have seen before, as we move the expiration cycle out a year, all volatility metrics suffer, including spreads. 

We’re looking at LEAP SPY options in our illiquid examples, but it’s important to note that low liquidity is much more common in less popular, niche stocks.

Ironically, meme stocks, despite their high volumes, are also known for having wide spreads. Why? Because market makers are hedging their risk. When a stock can swing 50% in a day, pricing options accurately becomes a real challenge! 

4. Bid/Ask Size

Size is perhaps the most frequently overlooked component in both stock and option liquidity measures.

In options trading, the spread tells us at what price we can buy and sell - but how many can we buy and sell at that price?

This is where size comes in. And size can tell us a lot about liquidity, whether we’re trading 1 lots or 1,000 lots. 

Take a look at the below options chain for XYZ call options.

We can tell right away that these markets are wide. And another red flag arises when we look at the size of the various bid and ask prices. 

Let’s assume we are feeling lucky and want to put $2k into XYZ 100 strike price call options, currently priced at $2.

Let’s also say we use a market order (which I have never used in 20 years of trading options). If we were only to look at the ask size, we would assume we would get filled at $2. 

We also know that since the bid is $1, our best case scenario is to sell them at the ‘mid’ point and lose $0.50 a contract. 

But we just want to get filled immediately, so we place a market order. Here’s how the fills for our 10 lot may come in:

• Bought 1 @ $2
• Bought 3 @ $2.30
• Bought 6 @ $3

That leaves us with an average fill price of $2.69. Ouch!

This happened because only 1 option was available at the price of $2, which is the quoted price typically displayed. The rest of the liquidity was higher up the chain, forcing us to get filled at worse prices as we ate up all the available liquidity. 

Who wins here? The market makers, of course. 🥩

Large Bid/Ask Size

Here’s how an options chain with a relatively healthy bid/ask size may appear.

💡Pro Tip: Some trading platforms display ‘level 2’ quotes. These quotes show us how many contracts are available to buy or sell at different prices. 

Liquidity: Wrapping it Up

In this article, we learned almost everything you need to know about options trading and liquidity. Let’s wrap it up by comparing side-by-side two option chains: one with thin liquidity and the other with robust liquidity.

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