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What Are Volume & Open Interest?
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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. Volume and Open Interest along with the
bid ask spread of each stock options contract work together to paint the complete liquidity picture in stock options trading.
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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 spread of about $0.05 to $0.20. This ensures that orders get
filled at the price that you see in the market 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!
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.
Volume, Open Interest And Liquidity
High volume and open interest usually results in a higher liquidity which shows up in narrow bid ask spreads. Therefore, the ultimate judge of
liquidity of stock options contracts really lie in the bid ask spread. However, sometimes 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, a highly liquid stock options contract should have a 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.
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