When trading options, there are numerous terms and concepts you must become familiar with in order to succeed. Today we will break down liquidity and slippage. To gain more insight on the subject,I spoke with Schaeffer's Senior Equity Analyst Joe Bell, CMT.
JB: Liquidity refers to how quickly a stock or option can be bought or sold without affecting the current market's price. It is important in options trading because options that are liquid are more likely to trade more easily and at a fair market price. If a stock or option is illiquid, it not only means that it may take longer to enter or exit the trade near its current market price, but that the asset's price may be affected by your transaction and ultimately your entry and/or exit price will be worse due to this.
JB: The bid price is the highest price a buyer is willing to pay for an option, while the ask price is the lowest price a seller is willing to accept. The bid-ask spread is the difference between the latest available bid price and the asked quote price for an option contract. Quite simply, the smaller the difference, the narrower the bid-ask spread. A narrow bid-ask spread is an indicator that the options are liquid.
JB: Options that trade frequently and have notable open interest tend to have narrow ask/bid spreads. These are options contracts that are relatively easy to enter and exit, due to their high built-in demand. Generally, the most liquid stocks will have the most liquid options. One can verify the liquidity of an option by the size of its open interest, volume, and bid-ask spread.
JB: Slippage refers to the percentage loss you would incur if you were to buy at the ask and immediately turn around and sell at the bid. The narrower the bid/ask spread, the less slippage.
Slippage also sometimes refers to the difference between the price at the time you make the decision to buy or sell an asset and the actual price at which you entered the asset. This can be significant when individuals or companies have large orders to execute relative to the security's trading volume. The difference between these two prices is affected by the amount you are buying or selling, the liquidity of the asset, the bid-ask spread, and volatility of the underlying security.
JB: Traders want to focus on options contracts that are liquid, with narrow bid-ask spreads, large open interest, and actively traded options. By ensuring the smallest possible difference between bid and ask price, you are reducing the risk of slippage impacting your profits.
JB: Traders can place a limit order for more control over entry and exit prices. The benefit of the limit order is that you, a trader, have price certainty on the entry/exit. In other words, traders know the highest price they will pay for the security when buying it, and the lowest price they will receive when selling it. The risk of the limit order is that a trader does not have execution certainty, and traders placing limit orders are not guaranteed a completed transaction.