Thinly traded derivatives are financial derivative contracts, such as options or futures, that experience low trading volume and infrequent transactions, resulting in limited liquidity and often wider bid-ask spreads. This characteristic makes them challenging to price and trade efficiently.
Mechanism
Due to minimal market participation, price discovery is inefficient, leading to larger gaps between buying and selling prices and potentially significant price movements with small trade sizes. Exiting positions may be difficult without incurring substantial market impact.
Methodology
Investors and institutions dealing with thinly traded derivatives, particularly in nascent crypto options markets or bespoke structured products, often rely on internal valuation models, request for quote (RFQ) systems for bilateral pricing, and direct counterparty negotiation. Risk management strategies must account for the amplified liquidity risk and potential for price manipulation, requiring careful position sizing and robust collateral management in smart trading environments.
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