Cheaper as she grows

Backtest Notebooks

Liquidity begets liquidity.

Other than “more buyers than sellers”, there is nothing more true in markets. People want to come to the party and trade because it’s the spot where others are trading.

It’s impressive that the SPX has more than quadrupled since the start of 2007, but even more material to options traders is the increase in activity and volume. One month average daily volume has increased nearly 8 fold to 3.2M contracts per day.

Volume drives liquidity because it advertises opportunity to both the buy and sell side. The increased activity means customers receive better prices on their orders, and the structural alpha community benefits from greater volume. Competition does its job, raising the bar for current participants and generating interest from new entrants, all supporting the flywheel.

As liquidity grows, it dramatically increases the range of strategies available to the buy side. More activity tightens the markets across strike ranges, and more complex strategies become feasible.

One of the biggest costs to an active trading strategy is crossing the spread, which gets all the more painful with increasing leg counts. A covered call only needs to find one option to sell, but setting up condor legs and crossing several spreads can add up quickly.

Activity drives spreads tighter, and also improves pricing. The spread is the uncertainty band around true value, and with more eyeballs trying to price that value, the better it becomes as a predictor. Improvements in liquidity are directly correlated with improvements in volatility risk premium pricing.

Today in the Backtest Notebooks, we’ll look at how spread widths have changed over time, and how that impacts the cost to trade a strategy.