LIQUIDITY IN THE STOCK MARKET MOST IMPORTANT METRIC IF WE ARE GOING TO TRADE OPTION CONTRACTS

Market Awareness and Liquidity
Market awareness refers to our ability to assess the entire stock and option marketplace from a macro level. Having a better market awareness allows us to avoid poor decisions and optimize our good ones. We like to break market awareness down in three levels: Sector awareness, fear awareness & participant awareness.

Sector Awareness
From the highest level, we want to have a good understanding of the different futures and where they’re at from an overall market perspective. We generally pay attention to /ES (S&P 500), /NQ (NASDAQ) and /YM (DOW JONES) for our equity overview. They have a high positive correlation, meaning they generally move in the same direction. From there, we can look at different commodities such as /CL (OIL), /NG (NATURAL GAS), /GC (GOLD), as well as interest rate futures and currencies.

It’s a best practice to keep an eye on the activity of these futures, as they bucketize a vast majority of the underlyings we will actually trade.

Fear Awareness
Once we have a grasp on the overall sectors and their activity, we dive a little further into the sentiment of the market. We use /VX (FUTURE) and the VIX (CASH INDEX) as our fear gauges. Both of these instruments measure the implied volatility of the S&P 500. This is important because implied volatility is not only an indication of implied movement, but it is also a gauge of option prices. When implied volatility is high, that means option prices are on the higher end of their spectrum. When implied volatility is low, that means option prices are on the lower end of their spectrum.

We generally like to sell premium when IV is high, and buy premium when IV is low. Keeping an eye on /VX & VIX prevents us from buying premium in high IV environments.

Participant Awareness
The third layer of market awareness has to do with the participants in the market. This is also known as liquidity. It’s important to have a gauge on overall market activity, because low activity levels are suboptimal. For a quick gauge, we can look at shares/contracts traded in SPY or /ES. Most of the market uses these instruments as their benchmark, so it makes sense that they’re some of the most liquid underlyings out there. Low volume in the stock and option market can create situations that are less than ideal. Wider bid/ask spreads, and the inability to get in and out of trades quickly are just two of the downfalls of illiquid markets. Additionally, when liquidity is low, we can see pretty quick and drastic moves to the upside or downside. This is due to a lack of resistance from the opposing side. If a big player steps in, there’s not a lot of resistance to keep the price from shooting up or down. For these reasons, liquidity is king!

Having an overall understanding of the market is a great first step to developing a portfolio and making more sound decisions. There are a lot of moving parts in the market, but if we focus on these three main macro aspects we can see things more clearly.

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