"Avoid Buying Options With Low Open Interest?"

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"Avoid Buying Options With Low Open Interest?"

"Is it advisable to avoid buying calls on options with low open interest? As an example - SHOO Dec 17 with 35 ITM Strike has an Open Int of only 246. I'm bullish on the stock but hesitant to pull the Options trigger due to the small open interest."
- Asked By Jean-Claude on 9 Nov 2011

Answered by Mr. OppiE

Hi Jean-Claude,

First of all, let us understand that liquidity in options trading is not only about open interest. In fact, it is not really about open interest at all. A high open interest is a by-product of a highly liquid options contract but an options contract with good liquidity may not always have a high open interest especially right from the start of its lifespan as well as options that are further in the money or out of the money. At the money options will typically have the highest open interest.

Open interest actually builds up over time as an options contract becomes more and more traded and always start at 0. In fact, an options contract with 0 open interest can also be very liquid as long as market makers are actively making bids for that contract. Such market making activity will typically show up as tight bid ask spread. As such, a better indication of whether an options contract is liquid enough is its bid ask spread rather than its open interest. Generally, a bid ask spread within 10% of the ask price is a pretty good indication that an options contract has good liquidity.

Options contracts with extremely high liquidity will almost always have a fairly high amount of open interest especially when they are at the money and has been traded for some time. So, what is a "high" amount of open interest? This is extremely subjective. Open interest can be as high as tens of thousands for heavily traded ETFs such as QQQ or as low as 20 for some stocks. Of course, we do not want to be the only "fools" to be buying and holding a specific options contract, right? So what I like to do is to make sure there is at least a certain amount, say 20 or 30, open interest for every contract I intent to buy. That will tell me that there are at least 20 or 30 other contracts out there for every one contract I buy, making me the "lesser fool". However, my first concern will still be the bid ask spread rather than the open interest.

In the case of SHOO, its options are very thinly traded and even though it has over 200 open interest, its bid ask spread are actually very wide. That tells me that those 200+ contracts may actually be held only by a few people (or even just 1 person) and market makers aren't actively competing for this contract, making them possibly hard to sell at a good price due to lack of liquidity.

However, must we avoid buying all options with low open interest and wide bid ask spread? Not really.

You really need liquidity only when you expect to buy and sell the contract quite quickly and want to do so at a good price. A tight bid ask spread would not only ensure liquidity but the fact that the bid ask spread is narrow also helps you sell at better price.

However, if you bought the options with the intention of pursuing a long call strategy by holding the options to expiration, then it really doesn't matter how much open interest that call options contract has at the point of purchase because you would be holding the position all the way to expiration without the intention of selling it in between. If you intent to hold the position all the way to expiration and allowing it to expire out of the money or exercised in the money, then you should not have to concern yourself with the bid ask spread or the open interest as long as the options premium works out to a sensible breakeven point for your specific outlook. Illiquid options can carry very high options premium due to market maker's need to compensate for their risk of making markets for an options contract that is not in good demand. In this case, if you intend to just hold SHOO's Dec35Call to expiration, your breakeven point will be $35 + $2.80 = $37.80. If you think the price of SHOO will exceed $37.80 by expiration and you wish to hold all the way to expiration, then this trade will be ok even at the current level of liquidity. However, if you think you are going to sell it anytime before expiration, then the liquidity may not be that ideal due to relatively wide bid ask spread.


In conclusion, the liquidity of an options contract depends on more than just its open interest. However, whether liquidity is a concern or not depends largely on the specific options strategy you are pursuing. You may want to read more about Open Interest and Volume to find out how they work and how they affect liquidity of an options contract.