Many traders often bring up the liquidity of an option as a concern for trading. Due to the complexity of the topic, we take this post to dig into the metrics commonly utilized by traders to gauge liquidity.
We examine options execution data to illuminate average execution slippage to provide guidance and transparency, while dispelling myths of perceived liquidity.
Products such as Nasdaq-100 Index Options (NDX) with large option chains are most susceptible to a perceived lack of liquidity due to lower open interest and volumes at each strike.
We evaluated over 50,000 executions of NDX for the average execution price with respect to the mid point.
We found that the bulk of volume and larger notional contracts traded well under 1% away from the midpoint, showing deep liquidity on executions, directly contradicting the common metrics.
Before diving into numbers, we want to define how we measured our findings. We identified slippage as the distance between the execution price and the mid point of an option. The further away from the midpoint a trade is executed, the larger the slippage. Deep liquidity is denoted when large contracts can be executed at or near the midpoint.
By analyzing where trades are filled with respect to this midpoint, we are able to provide some guidance on the true liquidity of NDX options. In the example below, we calculate both slippage in dollar and percentage terms.
Slippage in dollars: $2.05 (Exec. Price) - $2.00 (Midpoint) = $0.05 Slippage
Slippage in percentage: $0.05 (Slippage) / $2.00 (Midpoint) = 2.5% Slippage
Perception of liquidity
Many traders utilize open interest (OI) and volume to gauge an option's liquidity; however, we often found these metrics to be poor indicators. While it is true that options with high OI and volume typically have deep liquidity, the opposite is not always true. We found plenty of options with zero OI and volume that executed at the midpoint or within pennies of the midpoint.
Furthermore, the spread between the bid/ask quote, arguably a better metric for liquidity, has surprisingly stumped our research team. We found very low correlation between slippage with the size of the bid/ask spread. Hence we conclude that true liquidity is measured by the ability of large orders to be bought and sold near the mid point.
These findings lead us to focus on the metric that impacts your trading bottom line, slippage. As we stated in the summary, the average execution traded only 3% away from the midpoint.
However, as we dug deeper, we found that even this number was misleading as the bulk of volume and large trades were executed well below 1% away from the midpoint. Moreover, 14.8% of executions were filled at the midpoint!
We summarize our findings on slippage with the factors that affect liquidity, contract size, option price and delta to help provide some research on where orders are filled. Our research shows that NDX has surprisingly deeper liquidity than what the screens may display.
We were pleasantly surprised to find that larger institutional trades were receiving quality fills. Even trades of over $100m in notional value in a single execution were all filled with less than 2% of slippage, showing the true deep liquidity of the NDX product.
The price of an option is typically a large factor in the slippage of order executions. With an index valued at over 7,500, option prices often are quite large. Typically options that are very far away from the spot index value tend to have higher amounts of slippage, but in analyzing slippage by dollar amount, we find that it is actually well below the average.
The data broken down by Delta is not surprising, as options that are very low in delta (far away from the current price) typically will see larger amounts of slippage. While credit spreads with very low deltas are typical of index options trading, the data does show that at the extremes, slippage increases as a percentage of the execution price.
In conclusion, we find that despite lower open interest, volumes and wider bid/ask spreads, which may advertise a lack of liquidity, reality is quite the opposite. There clearly is a deep pool of liquidity available on Nadaq-100 Index Options. This knowledge seems to be reflected by the institutional traders who execute large volumes within 1% of the midpoint, but less so from retail traders.
Furthermore, credit spread sellers will find better liquidity by removing slightly higher up the deltas and higher priced options provide better liquidity. Lastly, our data show that the 67% of orders placed are filled within 2% of the mid point.