Illiquid Option Definition

How to determine liquidity of options, How Do We Measure Liquidity?

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By Chad Langager Updated Mar 1, An option is a financial instrument that gives the holder the right to purchase shares in a company at a certain set price strike price before a set date known as the expiration date. Options, however, trade far less frequently than other financial instruments such how to determine liquidity of options stocks or bonds.

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This can make it difficult for investors to enter into the option that they want. The best way to measure option liquiditytherefore, is to look at two factors: the daily volume and the open interest.

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The daily volume of a specific option contract is simply a measure of the number of times that contract was traded on a particular day. The higher this daily volume, the more liquid this option contract becomes as compared to options with a lower daily volume.

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However, because each day brings a new daily volume, it is not the most accurate measure of option liquidity. Furthermore, getting information on past daily volume is much more difficult to obtain than the vast information available on stocks.

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Another measure of option liquidity is the open interest of the option. So if the open interest was 1, this means that there are currently 1, options that are still active to be exercised or sold.

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Because an option is simply a contract, more can be created every day, but the current open interest gives investors an idea of the interest that investors are showing in that contract type. The higher the open interest, the more liquid the option contract is thought to be.

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Therefore, if you see an option that is traded times a day with an open interest of 10, it is vastly more liquid for investors compared to an option that trades 10 times a day with an open interest of 1, Compare Accounts.