Liquidity is a very important factor when trading options as it determines how easy it is to be filled at a competitive price when entering the trade, as well as how easy it is to exit the trade. Volume and open interest tend to be the first thing retail traders look at when considering liquidity, however, this does not give the full picture as to how liquid a product can actually be. Another misconception retail traders make is that market makers are "against them" when taking the other side of the trade. This is not true and by understanding the role and viewpoint of market makers, it can provide a more in depth understanding as to how liquidity can be found when trading options.

Trader Viewpoint:

Retail traders may have certain assumptions about executing trades such as:

• "There is another party on the other side of every trade."
• "If I lose money on a trade, the other side makes money."
• "Liquidity represents how easily is it to find a party willing to take the opposing trade."
• "If there is little volume or open interest, I will have a tough time getting in and out of a trade, because no one is willing to take the opposite side of my trade."

Because of these assumptions, market makers can be viewed by many traders in a negative light. However, this is far from the truth. The goal of the market maker is to make money on the spread, not on the performance of the trade itself. 

Market Maker Viewpoint:

• "Each transaction is an opportunity to make the spread."
• "Goal is to maximize the number of transactions, while minimizing risk."
• "Once I take the opposite position of an investor, I can hedge my risk against my existing book, or on the open market with shares of the underlying."

While it is true that market makers are on the other side of the trade initially, this is only for a short period of time as their priority is to eliminate the risk. This is done by either offsetting trades against each other (trades that other traders have taken) and hedge the rest with underlying stock (bringing net Delta as close to 0 as possible). Because market makers make their money from the spread, their goal is to maximize the number of transactions but to also remain neutral as they do not want to carry any directional risk on these positions. There is no incentive for the market maker should a trader’s trade do poorly. 

Single Leg Trade Execution

If a trader buys an Aug $360 Call (53 Delta), the market maker sells the same Aug $360 Call (-53 Delta), effectively taking the other side of the trade. Assuming there were no other trades on that contract for that day for the market maker to offset, the market maker will buy 53 shares of the underlying stock from the open market bringing their net Delta to 0 and is now hedged. This is why options with low volume and open interest can still be liquid as liquidity is contingent upon the ability to buy/sell shares of the underlying and not of the option itself. 

Spread Trade Execution (Multi Leg)

If a trader opens a spread trade, the market maker will only need to hedge against the net Delta. For example, a trader buys the Aug $360/$380 vertical (53 Delta - 30 Delta = 23 net Delta). The market maker will take the opposite side of the trade by selling the same vertical for a -23 net Delta. From there, the market maker will buy 23 shares bringing their net Delta down to 0. Again, liquidity is contingent upon the ability to buy/sell the underlying shares. 

Volume and Open Interest

As stated above, the volume and open interest of an option tells us very little about the actual liquidity of the option contract as market makers can simply buy/sell the underlying shares to execute the trade and hedge their position. However, looking at the open interest of the entire options chain can provide a better insight for liquidity. This is because market makers can partially offset their position by buying/selling different strikes to the trader that carry a different Delta, and simply buy/sell the underlying to offset their risk. 

Options Pricing

Option prices are displayed as a bid and ask spread. The bid represents the highest price someone is willing to pay for the asset (a retail trader would generally sell at the bid). The ask price represents the lowest price someone is willing to offer for an asset (a retail trader would generally buy at the ask). While this seems straightforward, it is also possible to get trades executed between the bid and the ask prices for a more competitive price - the mid-price. The mid-price lies between the bid and ask. This allows the trader to buy at a lower price than the advertised ask and sell at a higher price than the advertised price. Due to the complexities market makers face with regards to the number of symbols, expirations and strike prices, the most competitive price is not advertised, and market makers will be on the safe side by allowing some slack between the bid and the ask. This does not mean that trades will not get executed at better prices as that can easily be the case. The effective spread can be calculated as the execution price minus the mid-price.

OptionsPlay research shows that the effective spread on Canadian options is 58% from the mid-price:

Conclusion

Liquidity is a constant concern for traders who naturally not only want to be able to execute their trade at a competitive price but be able to exit the trade. However, many traders misinterpret or do not understand how to actually measure liquidity. By looking through the lens of a market maker, it provides a clearer picture on the liquidity of the option and how option liquidity is contingent upon the ease at which market makers can buy/sell the underlying asset to hedge their risk. It is also important to remember that an option's open interest and volume does not provide the full picture of how liquid it actually is and that traders should rather focus on the entire options chain to better gauge the liquidity of an option.

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