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Ask the Institute

DATE: December 03, 2012

QUESTION:

I once heard someone say, "The options on that stock are not very liquid."  Can you please explain what they meant by the term liquid?

ANSWER:
The term liquidity refers to the level of difficulty, or cost, involved in entering or exiting a position in a stock or an option.  Liquidity involves three parts.  The first part is the width of the bid-ask spread.  The width of the bid-ask spread is an important indicator of the level of liquidity of a stock or option.  The second part of liquidity is the size of the market.  The size of the market refers to the number of shares of stock or the number of option contracts that are bid for and that are offered for sale.  And, the third part of liquidity is the frequency at which trades occur.  There is more than one way to measure frequency of trades, but one quick and easy test is to compare the price of the last trade to the current bid and ask prices.  To learn more about liquidity, view this week's segment of "Ask the Institute."


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