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Take Liquidity into Account in your Trading Decisions Jim Graham
Investors require market liquidity. A market is said to be liquid if transactions can be executed quickly and easily. A trader should know the liquidity of the market that he is trading or wants to trade, and use that information when making trading decisions. On options exchanges, both Volume and Open Interest provide a good indication of market liquidity. The higher they are, the more liquid the asset. Volume is a number that tells you the number of contracts traded that day, just as the volume on a stock exchange tells you how many shares of stock have traded. The big difference between a stock and options exchange is that no security is "created" by the act of trading on the stock exchange. People simply trade the securities available back and forth. On an option exchange, however, an option can be created by the simple act of placing a trade. Before an option is traded, it simply does not exist. Open Interest tells you how many contracts are outstanding for each asset and in each individual option. How can you take liquidity into account with your everyday trading? The most obvious way is to use the volume, average volume, and open interest figures that are available for every option. If you are considering a trade, seeing volume that tiny or non-existent means you probably won’t be able to trade very many contracts at the currently quoted price. Worse, it may indicate that the position could be difficult to get out of if things move against you.
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Combining them to create indicators can also be useful, such as looking at the put/call ratio for volume and open interest. Bringing the additional information of options volume, open interest and the put/call ratio and seeing how they have reacted to past changes in the prices can be a valuable addition to your other technical analysis tools. 
You can also use liquidity characteristics to find trading opportunities. The Survey feature in OptionVue 5 lets you pick and sort assets by the greatest dollar volume of options traded In addition to a number of volatility characteristics as well. It also allows you to screen out low-volume candidates by inputting a minimum average dollar volume of options (DVO) traded. This quickly narrows a list of potential candidates to only those that meet or exceed your minimum DVO threshold. Volume figures can also be important when scanning the market for trading opportunities. Market scanning services, such as our OpScan, allow you to submit formulas over the Internet and quickly scan the entire market for potential trading opportunities. Using the built-in formulas or ones that you wrote on your own, you can scan for volume and open interest in a single option, all calls or puts in an asset, or all options in an asset by number of contracts. Volume can be defined as contract volume or dollar volume. Reports like these simplify the first step in making trading decisions.
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The next step is research. While market scanning services are useful for identifying trading opportunities, they only come up with a list of assets (or options) that meet the parameters set in the formula. It is important to do the additional research and make sure this is, in fact, a good trading opportunity. Find out what is happening in that asset. Look at what is happening in the industry and any news available. Let me take you through an example to show why it is important to do further research. One popular screen is to search for unusual call activity. The idea is to identify assets that may quickly increase in value, perhaps because of some news-related information such as a merger that is not yet widely known or priced into the underlying asset. The formula built into OptionVue 5 is designed to look for fairly liquid assets (defined as those that trade $250,000 of options volume or more each day, on average). It then looks for stocks where today’s dollar volume of options is five times greater than the average volume. From those, it then selects only those stocks where the call volume is at least three times the put volume. OpScan applies these parameters with no actual knowledge about the assets returned by the report, although you can be assured that whatever comes up does in fact have unusual activity on it. Below is an example of a recent report: 
One large stock on the list that showed up on a report recently was Oracle. The price was $15.91 a share at the time of this report. After the release of a good earnings report 2 weeks later, Oracle was $2.00, or 12.5%, higher. And from a price of $57.97 a share, Starwood hotels hit a high of 62.52, a 7.8% increase, twelve days later. Learn to use the tools available that let you take liquidity into account in all your trading decisions. Liquidity indicators and scanning tools can dramatically increase your chances of success in your trading. Most importantly, always understand what you are doing before you invest.
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