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# Option Liquidity formula ??

Discussion in 'Options' started by Digs, Jul 5, 2012.

1. ### Digs

I have these data types

B: Stock : Total Put and Call volume
C: Stock : Total Open Interest

Weights all equal
A:1
B:1
C:1

say I have 50 stocks I wish to rank them in best possible option liquidity ranking.

I though this formula might do it

SORT A highest to lowlest, rank stocks 1 to 50, with 1 being highest

SORT B highest to lowlest, rank stocks 1 to 50, with 1 being highest

SORT C highest to lowlest, rank stocks 1 to 50, with 1 being highest

Then to get overall ranking to this : RankA + RankB +RankC

So if a stock hard a perfect highest ranking it would be :
RankA + RankB +RankC =3

and the worst ranking would be :

RankA + RankB +RankC = 150

*****************
The above gives equal weight to all data types.

Question, is should I weight the data sets like this

A: 0.5
B 1.5
C: 0.75

Any ideas how to do this better??

2. ### diaoptions

You are very close. Below is the correct weight per data set.

A: 0.4757387
B: 1.5521823
C: 0.7294221

3. ### Digs

Are you pulling my leg, I am after good feedback?

any one

5. ### TskTsk

Weighing should be equal to the importance of each factor.

Also, it might be worth adjusting volume for price, as higher priced stocks often have lower volume, but can still be very liquid, relatively speaking.

6. ### trefoil

I only look at total volume (puts and calls) and total open interest. What the volume is in the underlying doesn't matter much.
I weight total volume more than open interest when looking at this stuff, but I never tried reducing it to a math formula. Volume to me is a better measure of liquidity.

7. ### kapw7

fwiw (as I'm a total newb ) in a recent academic paper I've read, the authors seem to favor bid/ask spread over volume or OI. So they use something like:

IL = (ask price - bid price) / mid price

Also volume by itself is not a reliable indicator of liquidity and you need for example to take into account the price impact as well.

8. ### Digs

Thanks, yes spread between front month BID and ASK is a good dataset to use.

yet I dont have that data.

I found this:

There is a common misunderstanding that liquidity is represented solely by open interest in options trading. That is wrong. Unlike stock trading where the best measure of liquidity is a stock's volume, volume is not a good measure of liquidity in options trading as many out of the money option contracts continue to be very liquid even though volume is very low. This caused many option traders turn to the next unique number, the open interest, as an indication of liquidity. This again is not accurate as every single option contract started out with 0 open interest when first launched in the exchange and then builds up open interest as more and more option traders buys that option contract. If 0 open interest means a completely illiquid option contract, how then does option traders build up a portfolio using that option contract?

In options trading, liquidity is really how quickly and willing market makers are to trade with you. When a stock options contract is first launched with 0 open interest, option traders buying that stock option is really buying them from the market makers and when market makers are confident of quickly hedging their positions with these stock options, they will narrow down the bid-ask spread of that particular contract but if they are not confident of being able to turn a quick profit from selling you a particular stock option contract, they will compensate that risk with a wider bid-ask spread.

Therefore, to ensure that a stock option has high liquidity, it should have high volume and open interest as well as a tight bid ask spread. An example of such highly liquid options are any stock options contracts on the QQQQ. Open interest and volume can also help to indicate unusually high level of activity on an options contract on days where volume exceeds open interest. Take together, Volume and Open Interest enables every options traders to determine the liquidity of any options contract before commiting to it.

Generally, at the money options (ATM) would have the highest level of volume as well as open interest, becoming less heavily traded as it goes more and more in the money or out of the money. This suggests that at the money options are generally more liquid than in the money or out of the money options of the same stock and expiration. This phenomena is due to the fact that most speculative and hedging strategies uses at the money options more than in the money or out of the money options. A simple example would be a Protective Put where investors buy at the money put options in order to hedge risk in a stock portfolio. Options traders speculating on a high volatile move in the near future would use a Long Straddle, which again consists of buying at the money call and put options.

9. ### TskTsk

Yeah, it's actually very hard to "measure" liquidity. I know personally on the ES future options, they look very illiquid but I very, very often get filled at better than midpoint from MMs. On other instruments the spread might be tighter but a midpoint fill is impossible. So there's a ton of factors at play here, that often can't be measured in any other way than trial and error.

10. ### atticus

Volume in notional terms. Honestly, any liquid underlying should afford ample option volume.

#10     Jul 7, 2012
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