Why Open Interest and Volume is Crucial in Options Trading

When trading options, what are the metrics that you should be most concerned with? Just price? Price is an important one. However, price movements are not the only essential pieces of information known to astute options traders. Paying attention to trading volume and open interest can also help you be more successful in your trading strategy.

Daily Trading Volume

The number or volume of shares or contracts traded in a particular period is known as the trading volume. Options volume is similar to daily trading volumes in underlying stocks, which give you an indication of the insights into the current interest. Large trading volumes can be an indicator of strong interest, but it must be viewed in context. It is a relative number. The values should be considered relative to average volume, such as the volume in the underlying stock. For example, look at the following scenarios and pick out which one is likely foreshadowing a more substantial and more sustainable move:

Option A

Price     Price Change     Daily Volume        Volume in Underlying Stock  

2.00           +1.00                    20,000              100,000 (25,000 average)

Option B

Price     Price Change     Daily Volume        Volume in Underlying Stock

2.00           +1.00                    20,000                50,000 (500,000 average)

You can see that the price change and daily volumes are identical. Daily volume seems to indicate sufficient interest at first glance. However, Option A’s underlying stock is trading at four times its average daily volume. This would represent a more “believable” move than Option B, where the underlying stock is trading at 10% of its average volume, despite making a 100% price gain on the day. Option B may be setting up for a reversal.

Open Interest

Another critical piece of important information to the astute options investor is the open interest. This indicator represents the number of active contracts that exist. Open interest is a data field that you will find on most quote displays, along with the bid and ask prices, volume, and implied volatility. However, it is not uncommon for traders to ignore this critical metric, much to their disadvantage.

What is included in the open interest total? In short, it is the total number of option contracts that currently exist in the market. This total consists of the number of contracts that have been traded but not yet liquidated by an offsetting trade, exercise, or assignment. In contrast to options trading volume, open interest is not updated during the trading day.

When Open Interest Changes (or Not)

1. When someone buys or sells an option, that particular transaction will be entered as either an opening or a closing transaction (i.e., ‘buy to open,’ ‘sell to close’). For example, if you buy ten calls from X, you are buying the calls to open (each contract represents 100 shares, so that would mean 1,000 shares in total.) That purchase will increase the open interest total by 10. If you wanted to get out of the position, you would sell those same options to close. The open interest total would then decrease by 10.

2. Selling options can also add to the open interest totals. For example, if you owned 1,000 shares of X and wanted to do a covered call by selling ten calls, you would be entering a sale to open. Since this would be considered an opening transaction, it would add 10 to the open interest total. Then, if you later wanted to repurchase the options, you would enter a buy to close the transaction. The open interest total would then decrease by 10.

3. Last, not all transactions are counted in open interest totals. For example, if you are buying 10 of the X calls to open, and you are then matched with someone selling 10 of the same X calls to close, the total open interest total will stay the same. 

Why does Open Interest Matter?

Many options traders likely ignore open interest altogether, as the total open interest of an option provides no way of knowing whether the options were bought or sold. This does not mean, however, that a trader should assume that there is no vital information there. For example, you can use the open interest metric to consider the relative volume of contracts traded. If the volume exceeds the existing open interest on a particular day, it means that trading in that option was extremely heavy that day.

Open interest can also offer you essential information regarding an option’s liquidity. If there is no open interest in an option, there is no secondary market for that option. On the other hand, when there is a massive open interest in an option, it means that there are large numbers of buyers and sellers in the market. This is an important point. If you have an active secondary market, it increases the odds of getting option orders filled at fair prices. All other things being equal, the bigger the open interest, the easier it will be to trade that option at a reasonable spread between the bid and ask.

Open Interest Scenario

Suppose you are looking for oil prices to go up in the short term. You search the available tools to bet on this move, and you go to buy a call on an oil ETF. Two alternatives to facilitate your suspicion that oil will rise are USO and USL. You look at the nearest month, at the money calls, and see that the USL open interest is 18, while the USO open interest is 9,761. This suggests that the market in USO options is more active, and there will likely be many investors in the marketplace who want to trade. The bid price of the option is $1, and the offer price of the option is $1.05. Therefore, it is likely you can buy one call option contract at the mid-market price.

On the other hand, the relatively low open interest in USL might be a red flag. This indicates there is a small interest for those call options, and that the secondary market is relatively weak, as there are fewer interested buyers and sellers. It would likely be challenging to enter and exit those options at reasonable prices. There is nothing more frustrating than being correct in your prediction, but not being able to realize the profits because you couldn’t get out of the trade at a good price.

Consider another recent example with actual data. Say that you are looking to enter a leveraged trade on Silver. You see the following options available:

Scenario A: SLV (1x Silver) at the money call

Bid         Ask        Open Interest

0.70        0.72             40,792

Scenario B: AGQ (2x Silver) Ultra at the money call

Bid         Ask        Open Interest

9.00       10.00              574

Which one are you taking? While you might not have all of the information necessary to make the decision, you can see the vastly different open interest, and the possibility that you might not be able to realize the gains that you should, given that you predicted the correct move.

Example Using Both Daily Trading Volume and Open Interest

Move         Daily Volume          Open Interest

 +2.00              2,000                       200,000

Move          Daily Volume          Open Interest

 +2.00                2,000                       2,000

Looking at just the daily volume for this option will not allow you to make any conclusions about which to buy. However, when you see that there is a big difference in open interest, it could make you question the trades even further. Why are either such a large of small portions of the open interest trading? Are traders eager to sell? Reluctant to sell? Is there limited interest? All of these data points are clues to helping you increase your chances of picking a winner.

Putting it All Together

It is important to realize that trading is not ever occurring in a vacuum. You can benefit from paying attention to indicators that show you what other market participants are doing, as this can shape your trading system. Daily trading volume and open interest are important tools that can be used to identify trading opportunities that you might miss otherwise. Most importantly, these indicators are some of the best for ensuring that your potential option positions are liquid, which allows you to enter and exit trades at the best possible prices.

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