What is Liquidity?
Who doesn’t love to invest in quick encashing options? Liquidity simply means encashing an underlying asset. Liquidity in stocks moreover plays fair. The stocks with high liquidity have the highest number of collective judgments of people’s opinions over the market.
More the opinions, the more liquidity in the market price. It is very quick and easy for the traders avoiding the redemption processes.
Once you make up your mind to encash your scrip the obvious question that arises is about the process. Firstly, let's take an overview of basic terminologies.
Bid price- The Bid price is the stated highest price for that underlying asset.
Ask and Bid Price- The difference between the last bidding price and the demanded quote price for an options contract. A Narrow bid price is a symbol of high liquidity in stocks which means less amount of deviation.
Open Interest- The total number of futures contracts held by market participants at the end of the trading day. It is the key element to traders as it defines the liquidity of an option underlying asset.
Trade Volume: It specifies the fascination of the other traders with the market price extent of that contract. Daily volume of a contract means the total number of times that contract was traded. Volume increases by one if initiated a new position and goes down by one while leaving the market. This applies to the buyer and the seller together.
Slippage: The amount of loss suffered if one buys at the ask price and straight away sells the same at its bidding price. The slippage will be always smaller if the bid price and ask price are less.
Function of Liquidity in Options & Futures Market -
By its open interest, trade volume, and ask-bid price, traders can gauge the liquidity of options. Liquidity in stocks is more beneficial to futures than options traders. Options with high liquidity are convenient and quick to trade with quality products.
High Liquidity in the market gives the assurance to enter or exit the market anytime. Though the market comes with loads of changes, the choices between what is demanded and what could be supplied are comparatively less. On the contrary, there is an illiquid option that cannot be easily converted into cash.
How to measure liquidity?
Basically, the liquidity of the market price could be determined by two methods: one is the volume of trade which states the number of times an underlying asset is traded on that particular day. The other one is by calculating open interest.
By open interest method, whenever there is a rise in OI the money will be flowing inwards. In fact, there is high liquidity when open interest for that trading day is more. Let us understand this with an example- Suppose a particular option was traded for 400 times with the OI of 20,000 then the liquidity of that option will be greater.
At a glance-
Liquidity is the measure by which we can instantly convert an option into cash which gives traders the market flexibility to freely enter/exit or trade in. It can be measured by Open Interest or the Daily Volume of those options. The option has a bid price by which it could be sold to its highest market price. Traders generally prefer options with high liquidity. But as said already everybody who is dealing in options trading must be aware of the inevitable risks despite the liquidity in options.