i've heard several ways to put a metric on liquidity of options.. obviously liquidity isn't a constant.. things like the Bid/Asks spread, liquidity of the underlying.. Trying to find a way to parameterize "liquidty" for scans... instead of contracts traded.. would some average of total dollar amount traded in some front part of the term structure work? does open interest say something as well?
I would look at the following metrics when quantifying "liquidity" in listed options:
- bid/offer spread
- number contracts traded and from that follows notional traded (in the option not underlying)
- frequency of bid/offer adjustments relative to changes in the underlying delta.
- frequency of liquidity added/removed on the bid and offer side even when no trades occur
- amount of liquidity added/removed on the bid and offer side even when no trades occur
- frequency of changes in spread dynamics
Most of the points above pertain to the fact that a lot of liquidity behind a contract is not shown on the screen, it shows however in the participation rate and dynamics of market makers and those who qualify for waivers of cancel/modify charges.
As an aside, I would not look at liquidity in the underlying. The underlying may be highly liquid without much interest in the options.
"Liquidity" has (at least) three different meanings here. They're all obviously interconnected
market impact: what is my ability to trade in this market without people noticing, and that moving the price? This is chiefly a function of depth, so open interest looms large. If there's X gross contracts already out there, then the market won't notice my new ones as much as if there were a fraction of X.
exit risk: if I get into any position, what is my certainty I can get out cleanly? If I'm trapped and others know, that's toxic. So how quickly could I get out, without anyone noticing, and that then having market impact? That's more of a function of ADV (average daily volume). The more others are trading, then the easier (or more properly, the quicker if you have to work the flow) it is for me to slip my exit under the radar screen without others knowing, and that generating market impact.
in-and-out cost: every time I trade, my broker takes the opposite position, that they then have to hedge. At least, should hedge. The market spread is thus a barometer of their willingness to take this risk, itself a function of their perceived comfort hedging it. So that's a pip or two on EURUSD; and somewhat more on the likes of EM inflation linked debt ;-)
All of which are fair, and very highly correlated with each other. My guess is that most people here just look at the last, and ignore the first two. Guilty as charged myself on that front. That's understandable. Chances are if your PA has market impact, you're not hanging around in these parts (no offence meant to a great platform).
If you want to gauge market liquidity, then the market isn't you and us here. Sorry but you're not big enough to matter. And that's actually a great thing (for you)! You're trading big numbers for you; but they're not small fractions of the money supply of a G10 currency nation! In a past life, I know people who have. And it's relatively easy eg in single stocks to get thus in any company's stock. It's the Woodford saga in the UK writ large (both on his exit from Invesco back in the day, let alone his current travails).
You, I and everyone else here is blessedly small-fry not to worry about those issues ourselves; but the market liquidity story isn't about us. It's about them, who are the bigger fish. Just as their views on prices matter for sentiment; their liquidity issues are what set the tone for everyone.
Any steer on market liquidity is thus a call on how easily they (not us) can trade. So while #1 and #2 above may not matter directly to us, they nevertheless matter. At least, in my less than humble opinion. Because if and when those become problematic for them, that's precisely when #3 that we do notice becomes problematic for everyone (ie including us).
After all, the real story with "liquidity" as a concept isn't the average, the ease or cost of trading in normal conditions; but the ability to trade when it really counts, when vol->infinity and correlation->1.
hope this helps.