Volume and Open Interest

What is open interest in options trading? How is open interest different from volume?

Volume & Open Interest - Definition

Volume is the total number of transactions filled on each stock options contract for the day. Open Interest is the total number of open stock options positions floating in the market place that is yet to be closed.

Volume & Open Interest - Introduction

Volume & Open Interest are one of the aspects of stock options trading that continue to baffle options trading beginners all over the world. Volume is the ultimate measure of liquidity in stocks trading but an additional measure called Open Interest is introduced in stock options trading. This led to the common misunderstanding that open interest is the sole determinant of liquidity in options trading. Nothing can be further than the truth. We shall explore in this tutorial the correct method of determining liquidity in options trading.

Why Does Liquidity Matter In Stock Options Trading?

Before the roles of Volume and Open Interest in determining the liquidity of stock options contracts are explained, it is imperative to understand what liquidity is and why it matters in stock options trading. What liquidity of stock options contracts mean is how readily they can be bought and sold at the market price. Stock options contracts that are highly liquid, or heavily traded, can be instantly bought or sold at the prevailing market price easily and instantaneously while stock options contracts that are less liquid or "thinly traded" tend to take a long time to fill and at very disadvantageous prices.

As in any form of trading, it is best to trade highly liquid instruments. Highly liquid stock options contracts gets filled quickly at the prevailing ask price and have an extremely narrow bid ask spreads. This ensures that orders get filled at the price that you see in the market when you want to and that bid ask spread loss is reduced.

Stock options contracts that have low liquidity gets filled very slowly as it is difficult to find a buyer or a seller in the marketplace. As the risk to market makers selling low liquidity stock options contracts is fairly high, that risk is compensated by a wide bid ask spread that increases the loss sustained upfront. In fact, if you hold very low liquidity stock options, it may even be impossible to find a buyer for those options!

Early in my options trading years, I have ever bought very illiquid options and held them all the way to expiration simply because no market makers are willing to buy them from me.

The volume and open interest of each stock options contract provide an indication on their liquidity, making it important to completely understand them.

What Is Volume?

Volume measures the number of transaction that took place on each stock options contract for that day. If a particular stock options contract is bought or sold 5000 times in a day, its volume will reflect 5000. Generally, the higher the volume of a stock options contract, the higher its liquidity. However, stock options contracts with little or no volume cannot be taken to be illquid as stock options aren't as heavily traded as its underlying stock and it does take a while for some volume to build up throughout the day.

Options volume is also used in the calculation of the popular contrarian indicator, Put Call Ratio.

What is Open Interest?

Open interest is the number of open positions floating in the market. An open position is created when you buy to open or sell to open a stock options contract which increases open interest by 1. When you sell to close or buy to close that position, open interest reduces by 1. Generally, the higher the open interest, the more a particular contract is traded and hence a higher level of liquidity. Again, a low open interest cannot be taken to be a sign of illiquidity as new stock options contracts starts from 0 open interest and builds it up over time. Open interest is also used in technical indicators such as Option Pain.

Volume, Open Interest And Liquidity

There is a common misunderstanding that liquidity is represented solely by open interest in options trading. That is wrong. Unlike stock trading where the best measure of liquidity is a stock's volume, volume is not a good measure of liquidity in options trading as many out of the money option contracts continue to be very liquid even though volume is very low. This caused many option traders turn to the next unique number, the open interest, as an indication of liquidity. This again is not accurate as every single option contract started out with 0 open interest when first launched in the exchange and then builds up open interest as more and more option traders buys that option contract. If 0 open interest means a completely illiquid option contract, how then does option traders build up a portfolio using that option contract?

In options trading, liquidity is really how quickly and willing market makers are to trade with you. When a stock options contract is first launched with 0 open interest, option traders buying that stock option is really buying them from the market makers and when market makers are confident of quickly hedging their positions with these stock options, they will narrow down the bid-ask spread of that particular contract but if they are not confident of being able to turn a quick profit from selling you a particular stock option contract, they will compensate that risk with a wider bid-ask spread.
However, bid ask spread can sometimes be misleading as bid ask spreads of very illiquid stock options can sudden narrow down in intraday trading due to one-off big orders being placed on it. This phenomena makes judging liquidity based on bid ask spread misleading too.
Therefore, to ensure that a stock option has high liquidity, it should have high volume and open interest as well as a tight bid ask spread. An example of such highly liquid options are any stock options contracts on the QQQQ. Open interest and volume can also help to indicate unusually high level of activity on an options contract on days where volume exceeds open interest. Take together, Volume and Open Interest enables every options traders to determine the liquidity of any options contract before commiting to it.
Generally, at the money options (ATM) would have the highest level of volume as well as open interest, becoming less heavily traded as it goes more and more in the money or out of the money. This suggests that at the money options are generally more liquid than in the money or out of the money options of the same stock and expiration. This phenomena is due to the fact that most speculative and hedging strategies uses at the money options more than in the money or out of the money options. A simple example would be a Protective Put where investors buy at the money put options in order to hedge risk in a stock portfolio. Options traders speculating on a high volatile move in the near future would use a Long Straddle, which again consists of buying at the money call and put options.

Volume and Open Interest Questions

:: Avoid Buying Options With Low Open Interest?