I just wanted to say a few words about liquidity.? You will often hear options educators say ?the first rule of trading is to trade liquid products.?? First, I want to reinforce that statement.? But, secondly (look away children), I want to say there are times when rules are made to be broken.
One of the most frequent questions I get from people I coach is ?how do I get my commissions lowered??? I do not mean to minimize the question as any time you can cut your costs, it is money in your pocket.? But, by comparison, the width of the bid / ask spread is far more important to your profitability than an extra 25 or 50 cents in commissions.? Let me illustrate this point with an (fictitious) example.? ?XYZ and ZZZ are two stocks that are both trading for around $30.? XYZ is a very liquid stock and its $29 puts are $0.45 bid and $0.47 offer.? ZZZ is illiquid and its $29 puts are $0.40 bid and $0.55 offer.? Assuming I need to buy the offer and sell the bid, I will give up $2 per contract crossing the spread on the liquid XYZ stock and $15 on the illiquid ZZZ stock.? A few things should jump out at you.
1.??? The difference in the slippage between the liquid stock and the illiquid stock is enormous when viewed as a percentage of the option price.??
2.??? If you believe the edge in trading options is generally 2-5%, the spread on the illiquid stock most likely renders trading that option unprofitable.
3.??? Both spreads are FAR more costly than the commission differential between the lousy commission structure you have and the fantastic commission structure you are hoping to obtain.??
Another point is you have a far better chance of bettering the bid / offer spread when you trade liquid options.? There are far more participants and thus, a better chance someone will trade in the middle.? And, perhaps most importantly (and you will not realize it until you have the misfortune of experiencing it), when the crap hits the fan, it will be next to impossible to get out of the illiquid option (if you are short) as all offers will seemingly disappear!
Finally, when a bid / ask spread is tight, the market is efficient.? That is, you can buy or sell the option at very close to the same price.? It is virtually a ?pick ?em? market.? You can trade what you want with very little slippage.
Convinced? ?Great.? Then why am I short NSR May 20 puts?? The front month, at the money puts are 40 cents wide and the options are certainly illiquid!? Well, once in a while, they give you so much perceived edge, that you just might want to play!? On April 16th, Neustar Inc. reported good revenues but a small miss on earnings.? The stock moved down to new 52 week lows.? Downside put buyers moved in, and due in part to the illiquidity of the options, the buyers moved the implied volatility of the May 20 puts (25% out of the money with 17 days to expiration) up to 176% on April 30th.? They continued to purchase the May 20 puts in bigger than normal size through Cinco de Mayo and I continued to sell them.? I get that the stock was near its 52 week low, but I could find nothing but decent reports on the stock.? Nothing dire seemed to be coming and the only thing that could explain that high of implied volatility (in my mind) was an upcoming announcement, of which I could find no hint.? If the crap does hit the fan, I will be forced to defend my position with stock as I know the put sellers will run for cover.? At least until the current put buyers decide to take profits.? And, when they do, they will probably drive the implied volatility down at least 100 percentage points to get filled. I will be waiting, in that event, and close out my stock and puts when the sellers (current buyers) reach near the end of their positions, as determined by the open interest.??
A dangerous game?? Perhaps. ?But, once in a while, the very thing that makes illiquid stocks a ?bad meal? can set the table for a feast.? It forces someone who insists on taking a large position to give up so much edge via the bid / ask spread and by driving the implied volatility so far afield, that all the downsides of trading illiquid options make it worth the risk.
Now, I am not proposing you run out and start trading illiquid options.? But, every trade is a transference of risk. If you pay me enough that I feel the risk is worth the potential return, I may break a few ?rules? and make the trade!