Price swings in the options market are a reflection of millions of traders’ choices to purchase or sell options. A competent options trader, however, is concerned with more than just the price. When trading options, you should also keep an eye on the daily trading volume and open interest. Understanding these two figures may assist you in making more educated investing selections.
Daily Trading Volume
The number of shares or contracts exchanged in a particular time is referred to as trading volume. When examining the underlying stock of the option, the volume might provide insight into the strength of the present price movement. Trading volume in options, like trading volume in stocks, is a measure of current interest.
However, trade volume varies. It must be compared to the underlying stock’s average daily volume. A big price shift coupled by higher-than-normal volume is an excellent indicator of market sentiment in the direction of the change. However, a large price gain followed by low trading volume does not always indicate strength. In fact, this combination might imply that a price reversal is imminent.
Options Trading: Volume And Open Interest
The number of active contracts is referred to as open interest. It appears alongside the bid price, ask price, volume, and implied volatility on most option quotation displays. However, many options traders disregard active contracts, which might have unintended implications.
The entire number of option contracts that are presently available is referred to as open interest. Contracts that have been traded but have not yet been liquidated by an offsetting transaction, exercise, or assignment.
Open interest, unlike options trading volume, is not updated throughout the trading day.
When you purchase or sell an option, the transaction is recorded as an opening or closing transaction. If you purchase ten calls from ABC, you are purchasing the calls to open. (Each call equals 100 shares, for a total of 1,000 shares.) This transaction will increase open interest by 10. You would sell the identical options to close if you wanted to get out of the position. Open interest would then plummet by a factor of ten.
Option sales might potentially increase open interest. You would be entering a sale to open if you owned 1,000 shares of ABC and wanted to conduct a covered call by selling ten calls. It would add 10 to the open interest since it is an opening transaction. If you wished to repurchase the options later, you would initiate a buy to close deal. The open interest would then be reduced by ten.
Why Open Interest Matters
There is no way to tell if an option’s entire open interest was purchased or sold when looking at its total open interest. That is most likely why many options traders disregard open interest entirely. You should not, however, presume that there is no relevant information there.
One approach to look at open interest is in relation to the volume of contracts exchanged. When volume surpasses current open interest on a particular day, it indicates that trading in that option was unusually high that day.
Open interest also provides important information about an option’s liquidity. There is no secondary market for an option if there is no open interest in it. When there is a lot of open interest in options, it suggests there are a lot of buyers and sellers out there. An active secondary market enhances the likelihood of having option orders completed at reasonable pricing.
All else being equal, the greater the open interest, the simpler it will be to trade that option at a decent spread between the bid and ask price.
For example, assume you check at Apple Inc. options and observe that the open interest is 12,000. This indicates that the market for Apple options is busy, and there may be a large number of people looking to trade. The option’s bid price is $1, while the option’s offer price is $1.05. As a result, you should be able to purchase one call option contract at the mid-market price.
Assume, on the other hand, that the open interest is 1. This shows that there is very little open interest in those call options and that there is no secondary market since there are so few buyers and sellers. Those possibilities would be tough to enter and quit at reasonable pricing.
The Bottom Line
Trading does not take place in a vacuum. Indicators that show you what other market players are doing might help you make better trading decisions. Trading volume and open interest on a daily basis may be utilized to find trading opportunities that you would otherwise ignore. These indicators may also help you ensure that the options you trade are liquid, enabling you to enter and exit trades at the best possible price.
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