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My strategy involves making profits from an increase in implied volatility on long straddles/strangles.

Enemy: Time decay

I am aware that the time decay accelerates. I read that for a 9 month options contract, time decay is:

  • 10% for the first 3 months
  • 30% for the second 3 months
  • 60% for the last 3 months

Friend: Implied volatility

Even though the longer contracts are costly, they are more sensitive to the implied volatility as vega is higher. Buying underpriced options ais most likely to provide an opportunity to sell if IV increases.

ENEMY: Slippage

Here is the problem. Even if I can overcome theta by IV, there is this slippage caused by having to both buy and sell. The more illiquid the market the greater the slippage. My concern here is:

  1. How liquid is the options market?

  2. How many stocks have options expiring in 9 months or more that also have sufficient liquidity?

Thanks.

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5 Answers 5

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The liquidity is quite bad. I have seen open Intrest drop from thousands to zero.

Theta and the lack of liquidity are strong reasons not to buy options. Instead, consider selling them.

They say that most Option purchases expire worthless. Why is this so? Because hedge funds buy those out-of-the-money puts in case their position goes against them (like insurance).

Make money selling insurance. No one makes money buying insurance.

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    Selling insurance is far riskier, though (it is after all the point of insurance). People don't go bankrupt buying insurance, but insurance companies do go bankrupt after major disasters...
    – Joe
    Commented Mar 10, 2016 at 20:21
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    The liquidity would be the same whether you are buying or selling, so not really answering the question, just stating your opinion in opposition to what the OP is looking to do.
    – Victor
    Commented Mar 10, 2016 at 21:11
  • They say that most Option purchases expire worthless. This is a heavily abused statement across the internet. It's not true. Per CBOE stats, about 70% of options are closing sells with 7% exercised and just under 25% expiring. Yes, the large majority of options remaining open at expiration expire worthless but this is nowhere true for all options in the lifespan of the series.
    – Bob Baerker
    Commented Jun 8, 2020 at 23:09
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The liquidity primarily depends on the specific equity type / position you are looking at. You want to look for stocks or ETFs that have significant volume themselves before trying to jump into an option contract.

The most important things you should look at are Volume and Open Interest for the specific contracts, strikes, and expiration. Near the money / in the money contracts from near term expiration tend to have the highest liquidity and the smallest (relative) spreads.

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ode2k noted the liquidity can very wildly especially 9 months out and there will be little volume even in the largest stocks. Victor noted standard measures of liquidity don't always apply cleanly to options as they are priced using a hybrid of model and market inputs. So your question is generally very hard to answer on SE, but you can get an answer yourself without too much trouble.

The best way to get a feel for slippage in your case is to just get quotes. Most systems should let you get a quote for both buying and selling options at the same time. This will give you a feeling for how much you are paying in spread. Do the same for near dated options to get a feeling for spread size when you end up selling.

You should factor in some widening of spreads at bad times, but this should get you a feeling for the scale of the slippage problem.

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Your 3, 6, 9 month decay numbers are in the ballpark but not necessarily accurate. The amount of decay in each 3 month period will vary according to the IV. Look at an option pricing formula to see this.

One FRIEND that you did not consider is that with long strangles and straddles, you also benefit from price movement in the underlying. Although it's a different approach, some people buy straddles and strangles 3-4 weeks before an earnings announcement hoping that the increasing IV going into earnings will offset much of the time decay, allowing you to hang in there, also hoping to catch a decent sized move in the underlying.

You're not going to find many option series expiring in 9 months or more with decent liquidity, let alone narrow B/A spreads.

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The liquidity of options is really not a problem, as the option price is determined by the underlying price, and even if there was very little liquidity in the option itself, market makers are required to make a market at the price determined by the underlying.

As long as the underlying has enough liquidity your slippage in trading the options should not be too much of a problem.

You can read this ETO Market Making Scheme document for more details.

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    To the downvoter read the article in this link: asx.com.au/documents/products/ASX_ETO_Market_Making_Scheme.pdf
    – Victor
    Commented Mar 10, 2016 at 20:40
  • If I place a limit order, will market maker respond to it? Or I need to wait for another guy like me to come and buy/sell it?
    – Distraction Arrestor
    Commented Mar 11, 2016 at 2:15
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    @DistractionArrestor - if your limit order is in the vicinity of the derived priced based on the movement of the underlying price, and there are no other orders from other investors, the market makers will provide a price. So say the underlying is at $40 and the option is at $1.00, and with every $1 move in the underlying the option price moves by $0.10. So if you place a limit order to buy the option at $0.90, if your order hasn't been filled by other investors by the time the underlying moves to $39, then the market makers will fill your order.
    – Victor
    Commented Mar 11, 2016 at 2:26

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