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Stock options is a derivative trading instrument where you can
utilize it to trade the underlying stock at a fraction of the cost of
buying the actual stock itself. Although stock option provides
leverage in terms of higher profit returns, don't forget that it is an expiring trading
instrument. Unless your option trading technique is able to lock in a
profit during the life span of the option, your option contract could
expire expire worthless if you are not able to anticipate the desired
movement of the underlying stock in the short-term accurately.
Although you can now trade a wide selection of stock options since
many stocks have become optionable, it is better to keep out illiquid
stock option from your options trading choices. Illiquid stock
options are options which are not heavily traded. Such low trading
volume is originated from the equally low trading action of the
underlying stock. Your first major disadvantage in trading illiquid
stock options would be the wide bid and ask spread slapped on you the
very moment you entered the trade. The other drawback is, let's say
you have purchased an option in anticipation for an event (eg.
earnings, acquisition announcement) and subsequently the underlying
stock made a price movement in the desirable direction, your profit
might still be curtailed because the wide bid and ask disparage would
be worsened by the collapse in implied volatility right after the
event. Moreover, if you are holding illiquid stock options and you
wish to offload them urgently, you are compelled to sell them with market order at the already disadvantaged bid price due to the low
demand and supply of such options.
So how do you determine whether a stock option is illiquid? As
mentioned earlier, they would have a wide bid and ask spread. The
slippage could sometimes be a difference of $0.30 or more, where the
market makers made a tidy profit from the spread just by providing
liquidity to investors of such stock options . The average daily
trading volume of the underlying stock of such illiquid stock would
usually be low, typically less than 200,000. The other way to spot
illiquid stock option would to look at the option trading volume
and open interest of the different options series, which would usually be very
little or sometimes with no trading volume.
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