Last week, we discussed the implied volatility rule to choose option strikes. This week, we discuss the liquidity rule, which combined with the implied volatility rule, will help you pick a call strike to buy when you have a positive view on the underlying.
The NSE offers European options on individual stocks and equity indices. European options give the right of exercise to the buyer only at expiry. Your objective of buying a call option is to sell it later at a higher price, not to exercise the option.
Now, picture a scenario where you have a long position in a 450 strike call option on a stock. The stock jumps from 450 to 500 with ten days for option expiry. It is possible that you may be unable to sell your option to capture the unrealised gains. Why?
Options are wasting assets because the right is less valuable with each passing day. So, traders do not want to pay large amounts to buy options. Now, in-the-money (ITM) calls (strikes lower than the spot price) cost more because they contain both time value and intrinsic value.
Therefore, as the stock climbs up, strikes closest to the spot price trade actively while liquidity declines for the rest of the ITM strikes. So, if you buy an ITM option based on implied volatility rule and the stock moves up, the option will become deep ITM and you may be unable to sell your option to capture profits. It would be, indeed, frustrating when your option position loses unrealised gains as the stock declines sharply after initially moving up.
Liquidity is, therefore, important. That is why you have to use one of three strikes — the ATM (at-the-money), one immediate ITM and one immediate OTM (out-of-the-money) for your trades, as these strikes are closest to the spot price.
How should choose the optimal strike? First, select the strike with the lowest implied volatility (the implied volatility rule). Then, check the change in the open interest for this strike. This represents long and short positions added each day to the existing open positions. A significant increase in open interest indicates signs of good liquidity.
If the strike you choose based on lowest implied volatility does not have good liquidity, then move to the strike with the next lowest implied volatility within the three strikes chosen above. Also, if you are applying the liquidity rule for NSE 50 Index options, ignore the strikes ending with 50. That is, if 13,650 is the one with the lowest implied volatility, then choose the strike that has the next lowest implied volatility. This is because strikes ending with 50 on NSE 50 index do not have good liquidity.
Suppose a stock trades at 238 and the 200 strike call trades at 40 points with 10 days to expiry. The option appears cheap because the time value is only 2 points. But the ITM strike would have last traded when the underlying was 225, translating to a time value of 25 points. Applying the liquidity rule allows you to focus on actively traded options, not on ITM strikes with stale prices.
Note that the liquidity rule is not as important when you trade American options. Why? You can exercise an option and capture its intrinsic value if you are unable to sell the ITM option.
Why not buy OTM options two or more strikes away from the spot price? For one, their price changes are small when the underlying moves up (low option delta). For another, these options typically have higher implied volatility. Why? If an underlying moves up, say, 50 points, you may not mind paying 13.50 points for an OTM option that last traded at 12.25 points. This will push up the option’s implied volatility because the price represents only time value.
(The author offers training programmes for individuals to manage their personal investments)