Volume and Open Interest

Volume is simply the number of contracts traded on a given day. Both volume and open interest are indications of the depth of a market. Neither is more important than the other. However, volume could be considered a more immediate indication of liquidity.

Open interest is the total number of contracts outstanding. To illustrate, say a new standard option contract becomes available. At first, its open interest is zero. Suppose you put in a buy order and I put in a sell order (both of us to open new positions). We make the trade. Now, open interest is one, because there is one contract open—you have the option to buy (presuming it’s a call) and I have the obligation to supply, if called upon, the underlying.

Now suppose more buyers and sellers come in, each side opening new positions, just as we did. This will make open interest go higher as new contracts are opened. However, if someone with a long position comes in with an order to sell, and gets matched up with someone with a short position who is buying to close, open interest will go down after they trade because contracts are being cancelled out.

If someone who is closing his or her position gets matched up with someone who is opening a position, open interest remains unchanged. To help picture this, suppose you and I are the only parties who have a position in an option. You’re long one contract and I’m short one. Therefore, open interest is one. What if you sold your contract to an interested third party? Now, you’re out of the position, the third party is long one contract, and I’m short one contract. Open interest is still one.

A high open interest simply says that a large number of contracts have traded during the life of the option, and that there is a potential for these open contracts to translate into more volume as traders unwind their positions. (Note the word potential, because traders do not have to unwind their positions if they don’t want to; they may hold until expiration and

then exercise.) If there is a large open interest in the nearby, at-the-money options, and it is the final day of trading for the nearby options, I have often seen the underlying stock price be driven toward the at-the-money option during the course of the day. This is one of the few instances when you can

observe the tail (the options) wagging the dog (the stock). It is not unusual to observe many stocks “locking in” on the price of the nearest strike price on an option’s final trading day. Is there any way to take advantage of this? I don’t believe there is one with a good risk – reward ratio. The idea of selling a straddle (selling both calls and puts) on or just prior to the final day comes to mind, but this is likely to backfire on you (by the stock making a significant move instead of staying quiet) just often enough to cancel out your profits in the long run. The one way I have used this knowledge to my benefit is when I’m one of those call or put holders who is hoping to recover even just a small amount before it is too late. As I look for the right time to sell, I keep in mind that there are many other traders in competition with me, and that I’d better take a decent price when I see it, without delay.

Happy Trading!!!

Cheers.