Liquidity is a term that is often used throughout the investing world. But just like with inflation, it can mean different things depending on the context.
Ask a central banker or an economist what liquidity means to them, and they’ll likely respond, “How much time do you have?” Generally speaking, investors and traders alike use the term to describe how easy or hard it may be to acquire or dispose of an investment. The more liquid the position, the easier it is to buy or sell, and typically the smaller the gap between the bid and ask price. Keep in mind that liquidity is always a relative term, meaning it is dependent on the nature of the underlying investment. Obviously, it is very easy to trade 100 shares of a company that typically sees more than 100 million shares trade hands on a daily basis. It is a very different thing to trade 100 shares of a company that, on average, only sees 1,000 shares trade hands daily.
Acquiring a sizable position in anything that is liquid is relatively easy. Just place your trade; it hits the order book and is executed almost immediately. Just another trade in a busy day, nothing to see here, move along, who’s next?
Trading something that is illiquid? That is another thing altogether.
If you’re looking to establish a sizable position quickly in an illiquid security, the odds are you will have a material impact on the price of that asset as your trade gets executed. In other words, you will create at a minimum a temporary price distortion that is, as some others phrase it, ”affecting price discovery.”
Remember Econ 101? Supply and Demand? When Demand is greater than Supply, prices rise. We see this play out over days or weeks in the economy, but on a trading floor, the effect is instantaneous. Once the surge in demand is over and the trade for this illiquid security has been executed, its price tends to drop back down to where it was, assuming there are no other participants willing to trade at that price level. If you are able to take your time and execute that trade over a period of hours or across days, as some large institutional firms do, then you would not have that same impact on the price during each trade.
Think of liquidity as how easy it is to buy or sell something. Selling a $20 used tennis racket on eBay is a lot easier than a $200 million Rembrandt because there is an abundance of used tennis rackets in the world and very few paintings by Rembrandt. Companies issue a set number of shares, which, combined with the daily trading volume and demand for shares, determines the price. In general, the fewer shares traded and the higher the demand, the higher the price and vice versa.
While liquidity in shares of a company is impacted by the number of shares outstanding that are available for trading in the public markets, options are different.
At the end of an expiration period, which is defined as "the Saturday after the third Friday" of any given expiration month, a new “series” is established. A series refers to contracts based on the same underlying security but at different strikes and expirations. A strike price is the price at which the option can be exercised.
As the calendar moves forward, price changes in the underlying security coupled with demand for other strikes will spur requests to market makers who will, in turn, make requests of exchanges to list these new contracts. When an exchange lists a new contract, it does not create those contracts. It essentially creates a spot for activity (quotes and trades) in those contracts to be recorded. The Options Clearing Corp (OCC) is the issuer of all option contracts and according to them there is currently open interest of 122,596 contracts over 14,430 strikes ranging from current weeklies out to LEAPS expiring in 2026 which represents over $156 billion of notional, or the dollar value of underlying exposure owning the contract gives you. These figures of course do not include positions that are opened and close intra-day. These permutations allow investor and trade to match their investment objectives across their time horizons.
When there are high levels of trading in any security, there is not a lot of ambiguity regarding price discovery. Buyers and sellers have a clear sense of where they want to transact, and that is reflected in the Bid/Ask spread. This spread is often quoted in USD, but a better way to think about spreads is in basis points (bps), or a 1/100th of a percent increment. After all, which trades tighter, an ATM NDX call ($300.00) at a $4.00 spread or an ATM NQX call ($75.00) at $1.25? Tough to tell in dollars, but in basis points, it becomes clear that, all else being equal, the NDX contract trades tighter at 133bps ($4.00/$300.00) versus the NQX contract at 167bps ($1.25/$75.00).
One other element of an option contract is the multiplier which indicates in terms of exposure how many units of the underlying that contract covers. Almost universally, it is set at 100. If an investor buys an NDX ATM (13,300 strike) call, she is spending $300.00 x 100 or $30,000.00 to get exposure to the equivalent of 100 shares of NDX. If she did this in the cash market (if it were possible to purchase shares of an index, more on that later) and bought those shares outright, she would have spent $13,300 x 100 or $1,330,000.00. The notional amount or dollar exposure of this trade is $1,330,000.00. As not everyone needs that level of notional coverage there are also options available on the Nasdaq-100® Reduced-Value Index (NQX) which represents a 1/5 notional amount of NDX. Further, there are also the recently launched Nasdaq-100® Micro Index (XND) options which represent a 1/100 slice of NDX notional and provide the same flexibility as NDX options but at a more suitable notional level for many investors.
Remember the “all else being equal” qualifier mentioned earlier? Oftentimes, options are bought and sold in order to establish or hedge a specific exposure on a given underlying security.
If you are at all familiar with indexes and Exchange Traded Funds, you will be familiar with the SEC-mandated disclosure that, “You cannot invest in an index.” That being said, trading Index options can give you exposure to the price movements of that index, and to determine the notional exposure, you follow roughly the same process as the above, except you take the underlying index level and apply the multiplier.
Another aspect of option liquidity is the question, “What do I need to do to establish or hedge my position?”
Let’s take a look at the previous example and, this time, include some figures for NQX and XND contracts. If you are an investor with a $500,000 portfolio and want to hedge your NDX exposure, an NDX contract provides too much coverage. Enter NQX options and the recently launched NDX Micro Index options (XND). NQX options represent a 1/5 slice of NDX (currently representing $254,000 in notional), and XND represents a 1/100 slice of NDX (currently representing $12,716 in notional), allowing investors and traders alike to appropriately size their exposure to the Nasdaq 100 Index.
Nasdaq-100 based index options (NDX, NQX, XND), contracts also differ in settlement from options that use equities as underlying securities. If an option contract is exercised, the writer of that contract is obligated to deliver what was promised. Options written on equities and exchange-traded funds employ what is referred to as “physical delivery,” meaning they require the writer to deliver the shares represented in the contract. NDX and other index options are "cash-settled," meaning the writer is obligated to fulfill the terms of the contract by paying the buyer any differential between the strike price of the contract and the final underlying value, assuming the holder is owed money at expiration. Cash settlement gets back to the disclosure that “You cannot invest in an index.” You can invest in vehicles that are based on an index, but you can’t invest in an index itself, hence cash settlement.
As an aside, many index options have a benefit when it comes time for filling out the IRS’ Schedule “D” in that index options (along with some other derivatives designated as “Section 1256” contracts) may enjoy what is known as 60/40 treatment meaning regardless of the holding period any gains (or losses) on index options will be treated 60% long-term and 40% short-term. Depending on how successful a trading strategy is and the determination of options on the underlying index qualifying as a “1256 Contract”, this could provide for some significant savings come tax time.
Option liquidity can be assessed by higher volume, and open interest figures and low or tight bid/ask spreads. Even if you are looking at a contract that has a fairly wide bid/ask spread, remember that displayed quotes are kind of like the MSRP (Manufacturers Suggested Retail Price) for securities. Nobody is going to force you to buy at the asking price, and you can always use a limit order when you drop that ticket meaning you can place an order (for that day or indefinitely) that will only be marked as actionable once your desired price is reached.
Ultimately, NDX-based contracts provide investors a highly liquid and deep suite of options products that, as stated earlier, allow investors and traders alike to match their investment objectives across their time horizons.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.