Liquidity is all about how quickly a trader can buy or sell something without causing a significant price movement. A liquid market is one with ready, active buyers and sellers at all times.
Here's another, more mathematically elegant way to think about it: Liquidity refers to the probability that the next trade will be executed at a price equal to the last one.
Stock markets are generally more liquid than their related options markets for a simple reason: Stock traders are all trading just one stock, but the option traders may have dozens of option contracts to choose from. Stock traders will flock to just one form of IBM stock, for example, but options traders for IBM have perhaps six different expirations and a plethora of strike prices to choose from. More choices by definition means the options market will probably not be as liquid as the stock market.
Of course, IBM is usually not a liquidity problem for stock or options traders. The problem creeps in with smaller stocks. Take SuperGreenTechnologies, an (imaginary) environmentally friendly energy company with some promise, but with a stock that trades once a week by appointment only.
If the stock is this illiquid, the options on SuperGreenTechnologies will likely be even more inactive. This will usually cause the spread between the bid and ask price for the options to get artificially wide. For example, if the bid- ask spread is $0.20 (bid=$1.80, ask=$2.00), if you buy the $2.00 contract that's a full 10% of the price paid to establish the position.
It's never a good idea to establish your position at a 10% loss right off the bat, just by choosing an illiquid option with a wide bid-ask spread.
How can you trade more informed?
Trading illiquid options drives up the cost of doing business, and option trading costs are already higher, on a percentage basis, than for stocks. Don't burden yourself.
If you are trading options, make sure the open interest is at least equal to 40 times the number of contacts you want to trade. For example, to trade a 10-lot your acceptable liquidity should be 10 x 40, or an open interest of at least 400 contracts. Open interest represents the number of outstanding option contracts of a particular strike price and expiration date that have been bought or sold to open a position. Any opening transactions increase open interest, while closing transactions decrease it. Open interest is calculated at the end of each business day.Trade liquid options and save yourself added cost and stress. There are plenty of liquid opportunities out there.