Is Your Stock Liquid Enough? Two Quick Checks

Key Concepts

• Liquidity: The ease with which an asset can be bought or sold in the market without significantly affecting its price.
• Tastytrade Liquidity Star Ranking: A proprietary ranking system used by Tastytrade to assess the liquidity of a stock.
• Bid-Ask Spread: The difference between the highest price a buyer is willing to pay for an asset (bid) and the lowest price a seller is willing to accept (ask).
• At-the-Money (ATM) Strike: An option strike price that is closest to the current market price of the underlying asset.
• Out-of-the-Money (OTM) Strike: An option strike price that is further away from the current market price of the underlying asset, making it less likely to expire in the money.
• Tastytrade Default Watchlist: A pre-selected list of stocks on the Tastytrade platform that have already been vetted for liquidity.

Assessing Stock Liquidity for Trading

This guide outlines two primary methods for determining if a stock is sufficiently liquid for trading, focusing on options trading.

1. Tastytrade Liquidity Star Ranking

• Purpose: This ranking system consolidates various relevant liquidity metrics for a given stock.
• Indicator: A stock with a three-star or four-star ranking is considered to be in good shape regarding liquidity.

2. Bid-Ask Spread Differentials in the Options Chain

• Methodology: This involves examining the bid-ask spread for options contracts related to the stock.
• Specifics to Check:
  • At-the-money (ATM) strikes: Analyze the spread on both call and put options at the ATM strike.
  • Slightly out-of-the-money (OTM) strikes: Also review the spread for options that are slightly OTM.
• Desired Outcome: The goal is to observe "pretty tight markets."
• Defining "Tight" (with examples):
  • For a $50-$60 stock: A bid-ask spread of 5 cents or less is considered tight.
  • For a $100 stock: A bid-ask spread of 10 cents or less is considered tight.
  • For $200-$500 stocks: A bid-ask spread of 15-20 cents is considered acceptable.

Bonus Tip: The "Lazy Man's Way Out"

• Method: Utilize the Tastytrade default watchlist.
• Benefit: All stocks included on this watchlist have been pre-screened for liquidity, simplifying the assessment process.

Conclusion

To ensure a stock is liquid enough for trading, particularly options, traders should first consult the Tastytrade liquidity star ranking, aiming for three or four stars. Secondly, they should examine the bid-ask spreads on ATM and slightly OTM call and put options, looking for tight markets that vary in acceptable width based on the stock's price. As a shortcut, the Tastytrade default watchlist offers a pre-vetted selection of liquid stocks.