How Market Structure Impacts Option Liquidity and Market Data
No matter the asset class you trade, liquidity is essential to taking a market position. High liquidity allows traders to efficiently enter and exit market positions at stable and desirable prices. In turn, it upholds the intentions of trade strategies and reduces slippage–thereby maximizing profits.
In the options market, seeking liquidity becomes even more important because of the market’s unique structuring and usage. Lower trading volume, instrument fragmentation, and hedging practices all create unconventional conditions that impact liquidity and how a Portfolio Manager or Head of Trading defines strategy. Understanding how market intricacies affect liquidity also enable decision makers to identify cost-efficiencies in market data.
Uneven Distribution in Options Liquidity
According to a 2017 study by Henry Schwartz, roughly 70% of options trading volume focused on the 75 most active instruments—representing less than 3% of listed options. If trading volume is any indicator of liquidity, the ability to take market positions is strongly skewed to select instruments.
The 10 Most Liquid Options
The skewedness of instruments is even more pronounced in the top 10 most actively traded options. In the second quarter of 2019, these 10 options represented 67% of total trading volume for the US options market.
Table 1. Average Daily Volumes for 10 Most Liquid Options, Q2 2019
|Rank||Instrument||Ticker||Underlying Asset Type||Trading Volume|
|1||SPDR S&P 500||SPY||ETF||5,462,499|
|2||Invesco QQQ Trust||QQQ||ETF||1,458,449|
|3||S&P 500 Index||SPX||Index||1,029,627|
|5||Cboe Volatility Index||VIX||Index||1,005,083|
|6||MSCI Emerging Markets ETF||EEM||ETF||773,052|
|8||Russell 2000 ETF||IWM||ETF||614,327|
|9||Advanced Micro Devices Inc||AMD||Stock||609,604|
Source: The Options Clearing Corporation (OCC)
Underlying assets vary in this list; however, they indicate that traders are focused on two types of options—those for ETFs and indices that are inherently diversified and those for highly liquid securities. Both scenarios suggest a risk management approach, where traders seek to hedge existing positions rather than uncover alpha. Preference for hedging strategies in the options market would further compound the skewed distribution of liquidity as traders continue to seek favorable and accessible pricing.
Unique Market Conditions Impacting Option Liquidity
In addition to the hedging and diversification behaviors of market participants in the option market, there are several structural factors inherent to the market that create unique conditions for traders seeking liquidity in options.
Lower Total Trading Volume
A large complication to sourcing liquidity in the options market is lower trading volume market wide. In June 2019, notional value of the options market was $67.8 billion, compared to the $324 billion in the US equities markets. At one-fifth of the market size, even liquidity on popular instruments is marginal to that of their underlying assets. Consider SPDR’s S&P 500 ETF (SPY), the most highly-traded options chain in the US markets. Average daily trading volume for SPY was 71 million for Q2 2019, while the options chain traded just shy of 5.5 million in the same time period. Lower trading volume in the options market introduces complications to liquidity that are further exacerbated by the fragmentation of the asset class.
Fragmentation in Option Chains
Innate to the structure of options chains, expiration dates and strike prices fragment instruments and dilute liquidity. Unlike the structure in equities, these characteristics decentralize liquidity, offering greater options to hedge a single equity instrument with. Therefore, in addition to defining the liquidity of an options chain overall, quantifying open interest and trading volume of a particular expiration date and strike price is necessary to gauge if an option is liquid enough for a trader’s strategy.
Liquidity may diminish for expiration dates that are soon or are months away as well as if those dates are not widely available. Likewise, strike prices too far in-the-money or out-of-the-money will lack interested traders in opposing positions to match the quotes. For this reason, liquidity may centralize on common expiration dates and strike prices, limiting the flexibility of a trade strategy.
Option Liquidity and Cost-Efficiency in Market Data Infrastructure
Two key measures of liquidity—trading volume and open interest—are available from level 1 data feeds. As a result, navigating the complexities in options liquidity is available without the expense of level 2 data. Instead, traders can access options from the OCC’s affordable offering, the Options Price Reporting Authority (OPRA) feed.
However, even with the OPRA feed, market data costs can be exorbitant. Infrastructure costs accrue in addition to exchange fees and are susceptible to the amount of data accessed. OPRA outputs a large volume of quotes that require a similar bandwidth allowance to accommodate. So, understanding how liquidity pools in the options markets enables traders to subscribe to select instruments and throttle their bandwidth requirements. In turn, this decreased load on market data infrastructure can reduce costs for an asset management firm or broker-dealer.