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.

RELATED FAQS
  1. What does high open interest tell you about an option?

    Learn about the open interest of options contracts and what a high and a low open interest indicate about the liquidity of ... Read Answer >>
  2. Does the seller (the writer) of an option determine the details of the option contract?

    The quick answer is yes and no. It all depends on where the option is traded. An option contract is an agreement between ... Read Answer >>
  3. How can derivatives be used to earn income?

    Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >>
  4. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
  5. Do options make more sense during bull or bear markets?

    Understand how options may be used in both bullish and bearish markets, and learn the basics of options pricing and certain ... Read Answer >>
  6. When holding an option through expiration date, are you automatically paid any profits, ...

    Holding an option through the expiration date without selling does not automatically guarantee you profits, but it might ... Read Answer >>
Related Articles
  1. Options & Futures

    Options Trading Volume And Open Interest

    Learn how these two statistics can give you an edge in trading options.
  2. Options & Futures

    Options Trading: Volume And Open Interest

    Options traders should look at daily trading volume and open interest to find ideas they might otherwise overlook.
  3. Options & Futures

    Introduction - Day Trading and Options

    Options have not been a tradition part of day-trading strategy, but this is quickly changing.
  4. Options & Futures

    Options Pricing

    Options are valued in a variety of different ways. Learn about how options are priced with this tutorial.
  5. Options & Futures

    Options Pricing: A Review Of Basic Terms

    The following is intended as a review of basic option terminology, which can be used as a reference as needed: American Options - An option that can be at any point during the life of the contract. ...
  6. Options & Futures

    Three Ways to Profit Using Put Options

    A brief overview of how to profit from using put options in your portfolio.
  7. Options & Futures

    How to Trade Options on Government Bonds

    A look at trading options on debt instruments, like U.S. Treasury bonds and other government securities.
  8. Options & Futures

    Options Basics: What Are Options?

    An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock ...
  9. Options & Futures

    Exploring The World Of Exotic Options

    Exotic options provide investors with new alternatives to manage their portfolio risks and speculate on various market opportunities. The pricing for such instruments is considerably complex, ...
  10. Options & Futures

    Getting Started In Forex Options

    Stocks are not the only securities underlying options. Learn how to use FOREX options for profit and hedging.
RELATED TERMS
  1. Exchange-Traded Option

    An option traded on a regulated exchange where the terms of each ...
  2. Call On A Put

    One of the four types of compound options, this is a call option ...
  3. American Option

    An option that can be exercised anytime during its life. American ...
  4. European Option

    An option that can only be exercised at the end of its life, ...
  5. Call On A Call

    A type of compound option in which the investor has the right ...
  6. Back Fee

    A payment made to the writer of a compound option in the case ...
Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center