Option Liquidity

Aug 2, 2007 by

When you want to sell a stock at its current market price, usually you can quickly find a buyer. For a market to form, there must be a set of buyers and a set of sellers offering goods at a range of prices. When the minimum amount that a seller is willing to accept is less than the maximum amount that a buyer is willing to pay, a sale takes place. What would happen if you showed up to a market and there were no sellers? It would be pretty hard to buy something.

 Recently, I began investing more in options. I bought an option during a dip in the stock market, and the option quickly became in-the-money. To my surprise, the price of the option did not change. How come, you may ask? The price of an option only changes when a transaction takes place. While changes in the value of an option are occurring every instant of the day, those changes are only recognized in a price change when the option trades. Thus, I watched my $64 call options on EWY remain at a steady $2.00, although the price of the underlying stock swung both above and below during the day.

Why was I investing in options in the first place?

As of the last week of July 2007, the market had been experiencing incredible volatility. In the words of the musician BT, “the only constant is change.” Frankly, I had no clue as to which way the stock market was headed, but felt that it was likely to continue oscillating a lot in the process. My goal was to try to buy some call options when I felt the market was near the bottom of one of its downswings, and then to sell the options once they had appreciated 30%. (Given the volatility of the market, options on many stocks and ETFs were swinging over 100% both ways.) For several stocks, this strategy worked quite nicely.

 Unfortunately, as not all options on ETFs are traded frequently, this strategy has not worked as well on my EWY (iShares Korea) options, as there simply has not been much trading volume. While the price of the underlying shares have swung, the options haven’t been sold frequently enough to experience significant swings as well. If you are wondering by what I mean by a lack of liquidity, on August 2nd, not a single contract of the option that I own was traded! Thus, the price of the option never changed to reflect the August 2nd price of the stock.

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  1. I think options are a great way for sharp, young investors to play the market without requiring excessive capital–it’s possible for someone to begin investing in options with only a couple hundred dollars.

  2. In many ways you are investing in volatility. That the market will continue to over and undershoot what might be considered the correct or fair value. With options you can magnify your results.

    Your points on liquidity are well noted. I focus on real estate and lack of liquidity presents many opportunities if you have the ability to weather periods with a mismatch between buyers and sellers.

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