The Relevance of Liquidity in Option Markets
All markets endure periods of illiquidity, yet for various reasons some are plagued with this phenomena for extended periods of time. When an option market is liquid, the margin or “spread” between the bid and the offer will narrow as the weight of competition assists in price discovery. In circumstances where option markets are illiquid, the absence of competition will necessarily mean that the bid/ask spread will be far wider.
Often the size of the bid/ask spread is a function of risk. It stands to reason that an option price is contingent upon an underlying instrument, and when that underlying markets is volatile, the risk of mispricing is accentuated. In these conditions, both sides of the market will seek to gain for themselves a buffer against mispricing, which in turn will be reflected in a wider bid/ask spread.
It is not only a volatile underlying market that will perpetuate a wider bid/ask spread. Liquidity or lack thereof will also create wider bid/ask spreads than would otherwise persist. In circumstances of illiquidity, the reality is that market participants are compelled to hold positions for a far greater period of time. In some case, option traders will have to maintain that position for months – possibly even until expiry. With this potential consequence in mind, traders in an illiquid market will also seek to exact as much value out of every trade as possible. In order to address the risk of lengthy open positions, and also basis risk of the underlying (which is assumed by the pricing model to travel at a constant volatility), a trader must demand a greater theoretical advantage.
Having executed a trade at the highest premium of advantage possible, the trader of an illiquid option market will then seek to adjust subsequent pricing in order to reflect the bias inherent in the current portfolio. This strategy underlies the premise that trading a portfolio of options is essentially spread trading options against each other. While value is captured by an individual trade, it is only translated into profit when it is realized. Realization of profits will only occur on cash settlement or closing out of an open position. An illiquid market by definition is the nemesis of closing out a position. Consequently, in order to capture the value and avoid erosion of profit, the open position needs to be offset by another open position. The closer the strike prices of the subsequent trade to that of the open position, the greater the utility of the value capturing taking place. Indeed, profit is a result of value being spread across a series of options.



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