How to Determine a Trade’s Liquidity

With stocks continuing to rally, many people are deciding to dip their toes in the stock market for the first time.

And, since my charts and trading technique can be new to some of my subscribers, I thought I’d answer some questions that I’ve been getting a lot of lately.

Even if you’re a long-time subscriber, I think everyone can still benefit from a refresher in these markets.

Here are a couple of the top questions I often get…

You frequently use Bollinger Bands when analyzing the VIX, but do you use them for individual stocks as well?

– Jonathan

Bollinger Bands (BBs) indicate the most probable trading range for a stock or index (click here to check out our free resources page, including our comprehensive glossary). They’re a useful tool for determining overbought and oversold conditions, and for pinpointing possible reversal trades.

For example, I often look for the major index charts to trade above their upper BBs, or below their lower BBs, and set up the potential for a sell signal, or a buy signal, when the indexes close back inside their bands.

These sell and buy signals have been quite reliable indicators, producing high-probability reversal trades on the indexes.

On individual stocks, however, the Bollinger Band buy and sell signals are not as reliable. Yes, the BBs do help indicate overbought and oversold conditions. But individual stocks can typically persist in those conditions where broad market indexes can’t.

So, BBs are less reliable at predicting reversal trades on stocks than they are on indexes.

When looking at individual stocks, perhaps the best thing to do is to see how the stock has behaved previously when it traded outside of its BBs. Then you can see if there’s a consistent pattern for that stock.

When you’re looking at various options, do you pay attention to the option interest and/or volume? Do you have a volume figure you look for before you go further, or is it more of the interest that you look at?

I see lots of options that have the interest at 5,000 or 10,000 and the volume is only 200 or 300. Just curious on how much attention you pay to those two sets of figures.

– Dave

Volume and open interest are both important factors when determining the liquidity of an option. Since my trade recommendations go out to a few thousand subscribers, we’ll often generate a huge amount of activity in the options I recommend.

It’s important that the recommendations be liquid enough to allow all subscribers to get into, and out of, positions relatively easily.

But, the most important factor in determining liquidity is the spread between the bid and ask prices for the option. (The “bid” is the highest price buyers are willing to pay for the option. The “ask” is the lowest price sellers are willing to accept.)

If an option trades with a one-cent spread, then there’s plenty of liquidity. It doesn’t matter how much volume there is, or how large the open interest is. If the difference between the bid and ask prices is only $0.01, then subscribers will have an easy time trading the option.

On the other hand, if the difference between the bid and ask prices is greater than $0.20, then there may not be enough liquidity to allow us to get into and out of the position at fair prices.

Most of the trades I recommend tend to be short-term oriented. So, we need to be able to get into and out of positions quickly. That’s not possible to do if hundreds, or thousands, of subscribers have to negotiate a wide spread between the bid and ask prices.

So, in addition to volume and open interest, I also look at the bid/ask spread before considering an option recommendation.

Best regards and good trading,

Jeff Clark

Are there any trading questions you want answered? Send them to [email protected] to be featured in the next issue.