Disclaimer: Options trading is considered extremely risky, 9 out of 10 traders incur a net loss, please trade responsibly. See the SEBI circular for more details
Let us assume that there are only two of us trading and if you want to sell something and I don’t want to buy, you would have no option but to agree to my terms, however, if there are 1000s of people trading, there is a much higher likelihood that someone would buy or sell the stock you want at the price which you want at. This is called the Liquidity of those stocks or options.
There are lots of factors that determine the Liquidity of an option, let us analyze them one by one.
Demand and Supply
This one should be fairly obvious if there is no demand for an option/stock then there would be no liquidity, conversely if there is no supply for the option then also there would be no liquidity.
If you take a look at the deep “in the money” (ITM) option there would be very low supply as the seller would have to take on huge risk for writing ITM options. This makes the liquidity of these strikes very low.
If you try to sell an option far in the future, there would be no demand for it, as no one wants to predict that far in the future, this would make the liquidity low.
Affordability
The premium of an option plays a big role in the liquidity of options. On the expiry day, the premium of the options is relatively very low and this makes lots of people trade in options who may not have large capital.
i.e. The premium of ATM (19800) option PE with 1 day to expiry is only 26.5 and the capital required would be Rs 1350, while the same strike PE for next week would be at 86.15 requiring 4 times the capital.
On the other hand, if you take deep in the money (ITM) options then the premium would be very high. The premium of the 20000 strike which is just 200 points away from LTP is 152.4 requiring 7 times the capital of the ATM strike.
Expiry
The stock options expire monthly while index options expire weekly. Weekly expiry means as a trader you have not blocked your capital for a whole month but only for a week to get your returns. This is a very attractive option for sellers who want to book their profits regularly.
Typically for an option buyer, once the market moves in the direction of their strike, they would typically book profit, however, sellers typically hold the position till the expiry as the decay on expiry day is maximum and sellers would stand to make maximum profit on expiry day.
If you are still confused about expiry, please see our detailed article on the expiration of options.
Risk
Risk also plays a big factor in determining the liquidity of an option. Typically the stocks can move quite drastically, thereby causing options premiums to go crazy. This was the case when Hindenburg published the report on Adani, Adani shares crashed more than 60%, which would have caused the Adani options to go to crazy numbers, and if you are holding a short position on such options and stock hits the circuit breaker, you are doomed.
However Nifty/BankNifty was reasonably stable during the Hindenburg saga, if you were holding index options, you would still survive the crash. This is one of the reasons why Index options are the preferred choice for most of the option traders.
How does liquidity affect traders?
If you are trading a non-liquid option, it can get very risky. Assume the market moves in the opposite direction of your strike, and you want to exit the position but there is no buyer or the buyer is offering a price that is way lower than the market premium. In such cases, you would be stuck into holding the position or accept a bigger loss than what would have happened if the option was liquid.
Words of the wise: Trading in low liquidity options is like playing a musical chair, some one will be left standing without a chair when the music stops
Conclusion
Overall a lot of factors come to decide the liquidity of any option, however, as a trader, it is always beneficial to trade in an option at a strike that is highly liquid.
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