Trading Illiquid Options

An important lesson to learn for successful option trading is the recognition of the drawbacks of trading illiquid options.

Now, technically, stock options with low daily volumes or low open interest (both of which can be seen on an option chain, such as with the examples below) are not themselves illiquid. It's the low volume or illiquid underlying shares that leads to limited trading activity on the options.

But for all practical purposes, I'm going to equate illiquid stock options with options that have subdued trading activity.

And the primary drawback on illiquid options is that you're going to get poor pricing when you initiate or adjust an option position.

The most obvious drawback to trading low volume stock options is a wide bid-ask spread.

When not a lot of options are being traded, or rather when not a lot of the underlying shares are changing hands, then you're going to be more at the mercy of the market makers, who also need to protect themselves from a low liquidity environment, and who often incorporate trades in the underlying shares as a way to hedge themselves when processing your order.

Here are a couple of examples for you to see for yourself - in the first one, JNJ was trading around $67.65/share at the time of this option chain screen print:

Now, unlike the JNJ (Johnson & Johnson) stock option example, where the at the money bid-ask spread is merely one cent, KIM (Kimco Realty) has much less volume, and as a result, you can see that the bid-ask spread is much wider, meaning than when you initiate a trade or attempt to adjust one, the market maker is going to take a significant cut:

Option Pricing Factors

To be fair, there are a number of factors that are involved in the bid-ask spread. It's not just volume in the underlying or activity in the options market itself.

But in a way, some of those factors are related to one another.

Take the JNJ example where the options are priced in $0.01 increments. The one cent increments has more to do with JNJ being a highly liquid mega cap company on which a lot of options are traded.

But that the at the money bid-ask spread is only $0.01 itself ($0.60-$0.61) is indication enough that even if the options were priced in $0.05 increments, that the pricing would be a lot more efficient (and attractive to option traders) than they are on a lower volume stock such as KIM.

Adjusting and Rolling Illiquid Stock Options

To me, the bigger problem with trading illiquid options isn't so much with the initiation of the trade but rather when it comes time to adjust or roll your position.

The way I trade options, I know to the penny and the annualized rate what my returns will be on that portion of a trade (I typically view option trades as more of a campaign or series of trades rather than a one time event). So, in that regard, even if the pricing isn't ideal, I know in advance what the numbers are and whether those terms will be acceptable to me.

But what happens if the trade goes against me? Because I focus on high quality companies and set up trades with true structural advantages, I almost never book a loss - instead, I'll roll and adjust the position to my long term advantage while continuing to book additional premium income throughout the life of the trade (or series of trades).

But in my experience, those adjustments and rolls are more challenging when dealing with options that have large bid-ask spreads. Poor pricing can mean the difference between rolling an underwater trade for still decent returns and rolling one for paltry returns (i.e. dead money).

The less flexibility you have when rolling or adjusting a trade, the bigger the headwind there will be to your ultimate success.

That's not to say that you should never trade an illiquid option (I actually held a 3 contract naked put position on KIM at the time of this writing), but you do need to recognize the structural disadvantages to doing so.

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