How do I measure option liquidity?

By Chad Langager AAA
A:

An option is a financial instrument that gives the holder the right to purchase shares in a company at a certain set price (strike price) before a set date known as the expiration date. Options, however, trade far less frequently than other financial instruments such as stocks or bonds. This can make it difficult for investors to enter into the option that they want. The best way to measure option liquidity, therefore, is to look at two factors: the daily volume and the open interest.

The daily volume of a specific option contract is simply a measure of the number of times that contract was traded on a particular day. For example, if the daily volume of the Ford $10 Dec05 call option contract is 15, this means that on that day, 15 option contracts to purchase Ford shares at $10 before Dec 2005 were traded. The higher this daily volume, the more liquid this option contract becomes as compared to options with a lower daily volume. However, because each day brings a new daily volume, it is not the most accurate measure of option liquidity. Furthermore, getting information on past daily volume is much more difficult to obtain than the vast information available on stocks.

Another measure of option liquidity is the open interest of the option. The open interest of an option contract is the number of outstanding options of that type (Ford $10 Dec 05) which currently have not been closed out or exercised. So if the open interest was 1,000, this means that there are currently 1,000 options that are still active to be exercised or sold. Because an option is simply a contract, more can be created every day, but the current open interest gives investors an idea of the interest that investors are showing in that contract type. The higher the open interest, the more liquid the option contract is thought to be. (For further reading, see Discovering Open Interest - Part 1 and Part 2.)

Therefore, if you see an option that is traded 500 times a day with an open interest of 10,000, it is vastly more liquid for investors compared to an option that trades 10 times a day with an open interest of 1,000.

To learn more about options, read Options Basics Tutorial and Options Trading Volume And Open Interest.

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