Liquidity with Options

Thursday, April 29, 2004

Strong liquidity in the options market for an ETF depends upon strong liquidity in the market for the underlying ETF. But further examination reveals that this is not sufficient. Some ETFs with large volume in long/short trading have relatively little options activity.

Whether the market is for ETF options or the underlying ETF itself, liquidity has many advantages. A liquid market has tighter bid/ask spreads so it is easier to get a fair price. More buyers and sellers shorten execution time. Liquid markets are more robust when markets touch inflection points, since more traders provide more opportunities to enter or exit.

Popular ETFs such as the Nasdaq 100 Trust (AMEX:QQQ), the DIAMONDS Trust (AMEX:DIA), and the Financial Select Sector SPDR (AMEX:XLF) have options that are actively traded. Options in the QQQ are more active than in any other ETF. On April 6, 2004 of the top 20 most active contracts traded, 14 were QQQ options. Some other high volume ETFs have options as well, but their options do not trade as frequently. Strategies executed in these other options are subject to liquidity risk.

A snapshot from April 2, 2004 of the most heavily traded ETFs with options is helpful for comparing options liquidity:

Fund Name One day Call Volume for April, 2004 expiration One day Put Volume for April, 2004 expiration Volume of ETF on 4/02/04 (AMEX) Bid/ask Spread of options
Nasdaq 100 Trust Shares (Amex:QQQ) 126,261 134,068 146,000,000 $.05-$.20
Financial Select Sector SPDR (AMEX:XLF) 51 151 11,048,800 $.05-$.30
DIAMONDS Trust, Series 1 (AMEX:DIA) 6,907 5,709 7,605,200 $.10-$.50
iShares Russell 2000 Index (AMEX:IWM) 1,385 3,857 6,413,600 $.05-$.40
iShares Lehman 20+ Year Treas Bond (AMEX:TLT) 1,006 6,945 2,603,700 $.05-$.30
MidCap SPDRs (AMEX:MDY) 140 2,690 1,509,400 $.15-$.80
Technology Select Sector SPDR (AMEX:XLK) 40 0 1,479,000 $.15-$.30
Industrial Select Sector SPDR (AMEX:XLI) 0 0 1,383,100 $0.10
Utilities Select Sector SPDR (AMEX:XLU) 0 0 1,296,300 $0.15

Source: Yahoo! Finance

This table shows that heavy options volume are always preceded by heavy volume in the underlying ETF. And where options volume is heaviest, best bid and ask spreads are the smallest. But heavy volume in the underlying ETF is not always an indicator of a liquid market for options.

Poor liquidity in either options or the underlying ETF adds risk to their trades by making them more difficult to convert to cash. Pricing will not be competitive and execution times slow. In down markets it may even be impossible to exit a position. So high volume in an underlying ETF is always welcome, but nothing can replace volume in the options themselves for creating liquidity.