Liquidity Technical Condition

Overview

The Liquidity Technical Indicator in TradeMachine® evaluates the tradability of an individual options contract by analyzing its bid-ask spread.

The liquidity is analyzed after all other conditions are met and an option is selected. If the bid-ask spread is too wide, and any option in the trade does not meet the liquidity condition, the trade is not placed. The backtester will then wait for the next time all of the conditions are met.

You can find this new technical condition on the Backtest tab under Technical Open Settings:

Unlike the Liquidity Filter, available on the Today Tab for Platinum subscribers, which applies to the underlying ticker, the Liquidity Technical Indicator operates at the specific strike and expiration level, ensuring that each option contract used in a strategy meets defined liquidity standards.

What is liquidity?

Liquidity refers to how readily an asset can be bought or sold in the market. While many point to open interest or volume in options to determine liquidity, that is very secondary to market width - they may reflect liquidity at times, but are not the defining characteristics. An option can see great trading volume or have large open interest and still be illiquid. Alternatively, an option can have no volume and no open interest, but still show great liquidity with a tight market.

Illiquid options are contracts that are difficult to sell quickly and convert into cash. These options carry higher risks, including wider bid-ask spreads, making it challenging for investors to sell them at a fair market price. Often, investors may have to retain these contracts until expiration.

How is liquidity utilized within TradeMachine®?

TradeMachine® uses a proprietary calculation based on bid-ask spread and the underlying price to determine option liquidity on a scale from 1-5 with 5 being the most liquid.

The Liquidity Indicator measures the relative width of the bid-ask spread for a given option contract.

Tighter spreads → Higher liquidity (more efficient execution)

Wider spreads → Lower liquidity (higher friction and slippage risk)

This ensures that trades are evaluated based on realistic execution conditions.

Proper liquidity usage in backtests has materially improved historical performance by ensuring trades are executed under realistic market conditions while avoiding distortions from illiquid pricing.

Here is how TradeMachine® determines liquidity:

• If the spread is less than or equal to $0.05, or if it's less than or equal to 0.0025 times the stock price, assign a score of 5.
• If the spread is less than $0.10, or if it's less than or equal to 0.005 times the stock price, assign a score of 4.
• If the spread is less than $0.20, or if it's less than or equal to 0.01 times the stock price, assign a score of 3.
• If the spread is less than $0.50, or if it's less than or equal to 0.03 times the stock price, assign a score of 2.
• If none of the above conditions are met, assign a score of 1.

• If the stock price is less than $5 and the final score calculated is more than 3, adjust the final score to 3.
  
  
• This is determined by looking at the closest options to 30 days to expiration. It looks at the 25 Delta options for calls and puts and then that is averaged.