Trading Options And Foreign Stocks: When Low Trading Volume Is Not Illiquid

Unlike stocks, options contracts can be created out of thin air. Because of this, the act of entering a limit order can create its own liquidity.

Covered call example

For example, I currently have a good-til-cancelled (GTC) limit order to sell CWEN/A June 19 2020 Calls with a strike price of $20 at limit price of $0.90. The person (or hedge fund) that buys my calls will be paying $90 per contract for the right to buy 100 shares of CWEN/A (Clearway Energy Class A shares) from me at any time before June 19, 2020.

I currently own all the shares I need of CWEN/A to cover this possible option assignment.Owning these underlying shares is what makes these contracts “covered” calls. If you are not familiar with covered calls, you can read more about it and four other hedging strategies here.

If I sell the calls at $0.90 as planned, and the contracts are not assigned (which typically happens if CWEN/A is trading at $20 or below on June 19), I get to keep the extra $0.90 per CWEN/A share. If the option gets assigned, I sell the shares for a net $20.90 each (including the $0.90 option premium) plus any dividends earned before the calls are assigned.

The reason I say that a hedge fund is the most likely counterparty for my options trade is that there are trading strategies using the underlying stock that allow someone who is long or short the options contract to completely arbitrage the risk inherent in the option position. When the price I am offering the option at (in this example) becomes higher than the hedge fund’s cost of shedding the risk inherent in the option through one of these strategies, the hedge fund will take the other side of my trade. This typically only requires a short spike in the share price because these hedge funds are using computers to constantly compare the cost of their trading strategies to the costs of options on offer.

Because these quant hedge funds will place trades to create new options contracts whenever the price is right, the effective liquidity of options contracts is much higher than it appears from the volume of actual trading.

Put another way, do not let the typical wide spreads you see between option bid and ask prices deter you from trading them. Just decide the price at which you are willing to trade, and place a good-til-cancelled limit order at that price.

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Disclosure: Long CWEN/A, MIXT, VLEEF.

Disclaimer: Past performance is not a guarantee or a reliable indicator of future results.  This article contains the ...

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