Have you ever been stuck in a trade you couldn’t get out of without taking a loss?
“Liquidity traps” in the options market are scenarios where an options contract doesn’t have enough open interest or volume to allow traders to exit a position easily. A lot of traders can fall into these kinds of options when there’s a tempting entry price. Still, on the other end, there is little to no demand for the option which makes it difficult to sell at a profit. Poor liquidity can wreck even the smartest strategy.
In this post, you’ll learn how to spot liquidity traps before you get caught. Once you understand the core causes for these options contracts and you’re aware of the key signs of a liquidity trap, you can start using strategies for avoiding illiquid options. We’ll even highlight some great tools you can use that help detect options contracts that might look enticing but are difficult to unload when the time comes.
What Is a Liquidity Trap in Options Trading?
In options trading, a liquidity trap refers to a situation where there’s not enough volume or interest for easy exit. The option’s price is so low that there’s little to no demand for the option, even in a scenario where the interest rates are reduced to zero. You often see liquidity traps in the options markets where interest rates are low (and approaching zero), but economic growth is stagnant or sluggish. Investors or traders are choosing to hold onto cash rather than invest in these otherwise great investment opportunities.
Although liquidity traps and stock liquidity are related, there’s a major difference between liquidity traps and stock liquidity issues. We’ve already described what a liquidity trap is and stock liquidity differs in that it’s the ease and speed with which certain stocks can be bought or sold on the market. Because there are more buyers and sellers available, investors and traders can enter or exit positions in a stock quickly and easily without it having a major impact on the price.
Common Cause for Liquidity Traps
What happens to make options contracts liquidity traps in the first place? We’ll address the common causes for these including issues with the underlying asset itself, the expiration dates, and the strike prices of the contracts you’re dealing with.
- Illiquid Underlying Assets—While these options might have a low price to enter, they come with the risk of being difficult to sell. They come with fewer interested buyers and wide bid-ask spreads. Traders might be able to get the asset for a good price, but they will have a hard time converting it into cash quickly or easily for its fair market value.
- Far-Out Expiration Dates—While the stock or asset might have a desirable price to enter, a lot of the value is tied into the time left on the contract instead of lying in intrinsic value. Options with far-out expiration dates can also be more susceptible to market fluctuations or unexpected events which can greatly devalue them during their extended life.
- Unpopular Strike Prices—These can contribute to liquidity traps by reducing the overall demand for options and causing the real likelihood of increasing the cost to exit positions. Unpopular strike prices lead to fewer buyers and sellers, resulting in wider bid-ask spreads, and are less likely to be actively traded.
Real-World Example of a Liquidity Trap
A good illustration of a liquidity trap in real life was when the housing bubble burst in Japan in the early 1990s. At the time when this occurred, it resulted in a period of stagnation in the economy where consumers and businesses preferred to hold onto their cash rather than use it for investing or trading in the stock or option markets. Even though interest rates were near zero and it was an excellent time to enter new positions in the markets, individuals and businesses didn’t see these opportunities as worth it and chose to hoard their money if the then-current economic conditions would deteriorate further.
Key Signs You’re Looking at a Liquidity Trap
How can you know for certain that you’re dealing with a liquidity trap when trading online options? Check out the primary signals of options contracts that are difficult to sell even when they come with a low entry price. These key signs can come in handy for traders who are looking to spot these traps, though it can be done a lot more efficiently with tools like option chain screeners and historic volume overlays.
✅ Pro Tip Box: “Always compare volume AND open interest before entering a trade.” – Can add something like this somewhere in this section.
1. Low Open Interest
When open interest is at or near zero, investors and traders find little incentive to invest in interest-bearing assets like loans, bonds, interest-bearing deposits, and other securities. The interesting thing about open interest is that low OI can be acceptable in options trading when you see consistent and strong price movements because this can be an indicator of a clear trend coupled with high confidence in the possible market direction.
While there isn’t an ideal open interest threshold due to it being dependent on the market conditions and the trading or investment strategy that someone is using, the general rule of thumb is to find options contracts that have at least 1000 open interest. This can be a sign of better liquidity and could make it easier to enter and exit these trades quickly.
2. Wide Bid-Ask Spreads
The bid-ask spread refers to the difference between the bid and ask price which is a strong indication of supply and demand. While narrow bid-ask spreads are a signal of high demand, wide bid-ask spreads indicate that fewer people are trading those options, stocks, or assets. Wide spreads signal poor liquidity because fewer people are trading them or are interested in dealing with them.
Example
$1.00 bid / $1.80 ask = 🚩
In this example, the investor or trader looking to purchase the stock would pay the asking price of $1.80. Anyone looking to sell the stock would sell it at $1.00. This particular bid-ask spread is considered a wide one and thus represents lower liquidity and less active trading for that asset.
Tips
- Use Limit Orders—By avoiding market orders and taking advantage of limit orders, traders can control the risks linked to illiquid stocks. These will allow traders to specify the maximum price when buying or a minimum price when selling. Using limit orders ensures that traders or investors don’t pay more or accept less than their desired price.
- Avoid Market Orders—Traders who are dealing with illiquid options should avoid using market orders which execute traders at the best available price in the market as soon as possible. Illiquid options usually have bid or ask prices that differ significantly from theoretical or last-traded prices which can lead to unfavorable trade execution or potential losses.
3. Unusual Strike or Expiration Selection
Both of these factors can signal that you’re dealing with illiquid options contracts. When you have unusual strike prices or expiration dates for these contracts, it can be a sign that there is potential price manipulation or large trades that are coming from smart money traders or institutional investors that are positioning themselves for future price movements.
- Danger of Exotic Contracts—It’s tougher to find the fair value of an exotic options contract compared to a standard contract. The risk that comes with exotic contracts is that the trader could possibly overpay for an option or they could sell it for less than it’s actually worth.
- At-the-Money or Near Expirations—Most of the time, you can find liquid options by finding contracts that are at-the-money (having a strike price that is close to the current market price of the underlying asset). Choosing contracts with closer expiration dates also signals that the position has more intrinsic value with the underlying asset than it does time value.
- Check the Volume at Each Strike—Traders can use options volume data to analyze option volume or open interest by strike price. This can help traders identify options contracts with low trading volume and wider bid-ask spreads, the primary indicator that the option in question is illiquid.
4. Inconsistent Volume Patterns
For the most part, illiquid options can be spotted for their inconsistent volume patterns due to their low trading activity. The erratic volume patterns can result in bigger price swings and some hardships in executing trades successfully, especially, larger order trades. Check out the best ways to monitor inconsistent volume patterns to find contracts that you’ll want to avoid due to liquidity issues.
- Watch for Daily Volume Spikes—While traders are monitoring the markets for illiquid positions, they’ll want to look for daily volume spikes that don’t match trends. If you’re seeing inconsistent volume patterns, it could be a solid sign that the option contract will be difficult to sell in the future.
- Avoid “Ghost” Volume Days—The last hours of trading on the third Friday of each month is referred to as “The Witching Hour” by traders or investors as well as the people in the financial world. During this time, traders will close out expiring contracts and roll positions into new contracts, which results in a period of increased trading volume and market volatility.
Tools to Help You Detect Liquidity Traps
Traders and investors should have a good idea of what illiquid options are for their general knowledge of markets and trading, but it’s best to avoid these kinds of options altogether, so as not to get stuck with positions that cannot be sold easily or quickly. Traders can detect liquidity traps by using tools like option chain screeners, historical volume overlays, and a few others.
Option Chain Screeners | This includes options like Thinkorswim, Tastyworks, or OptionStrat. It’s a table that lists all available option contracts for certain securities and gives a complete view of call and put options for each of the underlying assets. All options are organized by strike price and expiration date. Traders can use option chains to learn about how liquid the option contracts are featured. By reading the open interest and volume stats on an options chain, traders and investors can gain insights into how liquid each options contract may be. |
Use Historical Volume Overlays | These refer to technical indicators that are plotted directly on top of the price charts which can be used to visualize trends and identify possible support or resistance levels. The overlays offer traders insights into price movement patterns and therefore insights into the liquidity of the options contracts in question. |
Set Alerts | Another useful tool for investors and traders to detect possible liquidity traps is to set up alerts or notifications on their mobile device or computer for spread widths or open interest changes. |
Strategies for Avoiding Liquidity Traps
If you’re looking to avoid liquidity traps altogether, there are several methods and strategies for working in a proactive manner where you aren’t running across any of these illiquid options contracts. The more you can work these tools or routines into your trading sessions, the greater the likelihood that you’ll avoid liquidity traps altogether.
Stick to High-Volume Tickers
Arguably the best way to keep away from liquidity traps is to choose options contracts that are high volume, which you can find on tickers like SPY, QQQ, and AAPL. You have very little chance of running across contracts that are illiquid in these places.
Avoid “Oddball” Contracts
Unless you have a good reason, options traders should avoid oddball contracts, which are options that deviate from the standard contract specifications. They come with non-standard expiration dates and strike prices—they aren’t as widely traded due to their wide bid-ask spreads and low liquidity.
Use Spreads Wisely
Liquidity risk increases with complexity, so traders should use spread strategies in a way where they aren’t getting into situations where they could be stuck with illiquid contracts.
Always Double-Check Bid-Ask
A good habit to get into before entering any trade is to double-check the bid-ask spread. Illiquid contracts are generally characterized by a wider bid-ask spread, so it’s best to stick with narrower spreads. This can do a world of wonders for keeping traders away from liquidity traps, paired with high-volume tickers.
Consider Rolling or Exiting Early
Perhaps you already have a liquid options contract, but the liquidity begins drying up for whatever reason. You can take two paths—either roll the contract to a further expiration to give yourself more time to be profitable or exit the trade early to mitigate potential losses.
What to Do If You’re Already in a Liquidity Trap
Maybe you’ve already made the mistake of falling into a liquidity trap. What do you do from there? How can you get out of the trade and do so taking the least amount of damage possible? We’ve outlined some good practices to implement when you’re in a liquidity trap and some great strategies for managing the position to keep the biggest amount of your money intact while you plan your exit.
- Remain Calm—If you find that you’re in a liquidity trap with your online investments, it’s key to remain calm and not to panic. Go about putting together an exit strategy where you can get out of the position without losing too much of the money you have in the investment.
- Try Limit Orders in Increments—Traders can place limit orders to avoid being forced to trade at an unfavorable price due to a lack of liquidity. By using these orders in increments, traders can gradually exit these positions in baby steps and therefore incur minimal losses with each part of the exit plan.
- Use Legs of Spreads—This strategy is great for exiting liquidity traps piece by piece, similar to using the limit orders in increments.
- Consider Holding to Expiration—Your best course of action might be to hold the option until the expiration date if the risk is manageable. It might be a waste of your time and money to attempt an early exit, as these contracts have little volume or open interest. The most viable path might be to sit tight and let the contract expire as worthless.
- Avoid Doubling Down—Unless you have high conviction about the trade turning around, it’s best to avoid doubling down on a losing position and deal with it sooner rather than later. You might have to let the contract expire as worthless. It all depends on how likely you’ll be able to get an interested buyer.
Stay Liquid, Trade Smart
The key to staying away from liquidity traps is to simply embrace options contracts that come with high volume and open interest. Know the warning signs of liquidity traps: low volume/open interest, wide bid-ask spreads, and unusual strike prices or expiration dates. Traders who can avoid these odd contracts altogether and stick with the high-volume tickers shouldn’t have too much trouble in finding options contracts that can be easily and quickly sold when the time comes.
Avoiding these situations is as important as picking the right strategy. Remember, if you’re in the midst of a liquidity trap, it’s best to stay calm and begin planning your exit, unless it’s more favorable for you to stick it out to expiration. Traders can use the legs of spreads or limit orders to exit incrementally.
Next time you scan the option chain, use these tips to stay liquid and nimble.
