In our quest to understand trading options for income, we spend most of our time locating good chart patterns supported by our favorite indicators, and often forget to consider the liquidity of the underlying's option chain. Not only does the lack of liquidity make it difficult to adjust or exit a position, it has a steep cost due to wider bid/ask spreads.
Liquidity is a crucial criterion in the selection of an underlying. It is not enough to limit our selection to equities or ETFs with high daily volume (typically in excess of 1 million shares), it is also important to review the option chain to ensure it has both depth and breadth: the greater the depth, the more strikes are available; the greater the breadth, the higher the volume and open interest at each strike. As depth increases, we find that the increment between strikes grows smaller (typically, $1 to $5, based on the price of the underlying. As breadth increases, we find that the spread between the bid and ask gets smaller.
In addition, we rely on the Probability Model to calculate the location of our short strikes using the 1 SD (standard deviation) expected move (or multiples thereof). Option chains lacking liquidity are inefficient resulting in skewed option prices, and this leads to distortions in IV (implied volatility) and corresponding probabilities.
To get an idea of the costs, Tasty Trade looked at the following stocks using a 1 lot Strangle with varying bid/ask spreads for one year of earnings: INTC, JPM, NDAQ, and PDCO. They took the spread x 100 x 2 contracts x 2 (round trip) x 4 earnings cycles. The theoretical slippage costs ranged from $16 to $240.
Taking this to the next level, Tasty Trade tested the effects of option chain liquidity over an extended period. To do this, 3 liquid (option bid/ask spread of 1 - 2 cents) and 3 illiquid stocks (option bid/ask spread of 10 - 15 cents) were selected and traded only during earnings over 5 years.
The results: the liquid stocks had a theoretical slippage cost of $240 to $480, while the illiquid stocks had costs ranging from $2,400 to $3,600 (assuming fills could be made).
In conclusion, we can see that illiquid option chains can be very costly. This test assumed that fills were made, when in reality many would not have been filled even at market prices (since the market maker will increase the market price). It is, therefore, imperative that you trade only underlyings with liquid option chains.
If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.