Price movements in the options market result from the decisions of millions of traders. But there are a number of useful statistics besides price movements that tell you what those other market participants are doing. Here we take a closer look at two factors you should consider when trading options: daily trading volume and open interest.
Daily Trading Volume
Trading volume is the number of shares or contracts traded in a given period.
When looking at the option's underlying stock, volume can give you important insight into the strength of the current price movement. Keep in mind that trading volume is relative and needs to be compared to the average daily volume of the stock in question. A large percentage change in price accompanied by higher-than-normal volume is a solid indication of market strength in the direction of the change. But large percentage increases in price accompanied by small trading volumes are less likely to indicate a market direction. In fact, they may indicate that a reversal is likely in the near term.
Just like with a stock, trading volume in an option measures the activity in the option and represents the number of option contracts being exchanged between buyers and sellers.
Options Trading: Volume And Open Interest
The Importance of Open Interest
Open interest is a concept all option traders need to understand. Although it is always one of the data fields on most option quote displays – along with bid price, ask price, volume and implied volatility – many traders ignore open interest. While open interest may be less important than the option's price, or even current volume, it provides useful information that should be considered when entering an option position.
First, let's look at exactly what open interest represents. Unlike stock trading, in which there is a fixed number of shares to be traded, option trading can involve the creation of a new option contract when a trade is placed. Open interest will tell you the total number of option contracts that are currently open – in other words, contracts that have been traded but not yet liquidated by either an offsetting trade or an exercise or assignment. As opposed to options trading volume, the open interest is not updated during the trading day.
For example, say we look at ABC stock and open interest tells us there have been 81,700 options opened for the May 27.5 call option. You may be wondering if that number refers to options bought or sold. The answer is that you have no way to know for sure.
When you buy or sell an option, the transaction needs to be entered as either an opening or a closing transaction. If you buy 10 of the ABC May 27.5 calls, you are buying the calls to "open." That purchase will add 10 to the open interest figure. If you wanted to get out of the position, you would sell those same options to "close," and open interest would then fall by 10.
Selling an option can also add to the open interest. If you owned 1,000 shares of ABC and wanted to do a covered call by selling 10 of the May 27.5 calls, you would be entering a sale to open. Since it is an opening transaction, it would add 10 to the open interest. If you later wanted to repurchase the options, you would enter a transaction to buy to close. Open interest would then decrease by 10.
Things get a little more complicated if the options you trade are not created by the transaction, but instead the other side is taken by someone doing a closing transaction. For example, if you are buying 10 of the ABC May 27.5 calls to open, and you are matched with someone that is selling 10 of the ABC May 27.5 calls to close, then the total open interest number will not change.
So, when you are looking at the total open interest of an option, there is no way of knowing whether the options were bought or sold, which is probably why many options traders ignore open interest altogether. However, you shouldn't assume that the open interest figure provides no important information.
One way to use open interest is to look at it relative to the volume of contracts traded. When the volume exceeds the existing open interest on a given day, this suggests that trading in that option was exceptionally high that day. Open interest can help you determine whether there is unusually high or low volume for any particular option.
Open interest also gives you key information regarding the liquidity of an option. If there is no open interest for an option, there is no secondary market for that option. When options have large open interest, it means they have a large number of buyers and sellers, and an active secondary market will increase the odds of getting option orders filled at good prices. So, 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.
For example, suppose you look at options on Apple Inc. when the stock's price is trading at $124.00 and see the open interest of the April 125 call options is 12,000. This indicates the market is likely to be active, and there may a lot of investors in the marketplace who want to trade. The bid price of the option is $1.00 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, suppose you look at the April 150 call options and see the open interest is 1. This indicates there is very little open interest on those call options and there is no secondary market, because there are very few buyers and sellers. Therefore, it is difficult to enter and exit those options at good prices.
The Bottom Line
Trading does not occur in a vacuum. Indicators and reports that show you what other market participants are doing can be a valuable addition to your trading system. Daily trading volume and open interest can be used to find trading ideas you might otherwise overlook. These indicators are also useful for making sure the options you trade are liquid, allowing you easily to enter and exit a trade, as well as ensure you get the best possible price. Those interested in options trading and looking for further information on how to get started can check out Investopedia's list of the best online brokers for options.