Volume and Open Interest

Introduction

The liquidity of an option is an extremely important factor to consider when trading options.  Unfortunately, many option traders do not understand how to properly gauge the liquidity of an option or how to assess its impact on the price of an option.  The liquidity of a stock is simply measured by the daily volume of trades on that stock.  For options, liquidity is measured not only by daily volume but another indicator called open interest.

What is liquidity and why is it important?

Liquidity is a term used to describe the extent to which a security can be bought or sold in the marketplace without its price being affected.  A security is said to be liquid when it can be readily bought and sold in the market without an inordinate effect on its price.  Let’s examine these two components of liquidity in more detail.

The first component is that the security may be easily traded at any time.  A security is easily traded when there are a large number of buyers and sellers (other than the market makers) ready to trade the security any time the market is open for trading.  If there are very few buyers and sellers or none at all trading a security, the security is illiquid.

The second component is that the security can be bought or sold without a substantial impact on the price of the security.  In other words, the security can be purchased in large quantities without the price moving up substantially against the buyer and it can be sold in large quantities without a substantial loss in value to the seller.  If large quantities of the security cannot be traded without a substantial impact to the price of the security, then the security is illiquid.

Trading illiquid options makes it more difficult to realize a profit on the trade because of the wider spread between the bid price and the ask price of the illiquid option.  The wider bid/ask spread means that the illiquid option must increase in value to a greater extent than a liquid option with a narrower bid/ask spread in order for the trade to achieve the same profitability.

What is volume?

Volume is a measure of the total number of option contracts that are traded during the trading day in a particular options series.  If an investor buys 105 Microsoft March 35 call options and nothing else trades in that series for the rest of the day, the daily volume for that series will be 105 contracts.  Generally speaking, the higher the volume for an option contract, the more liquid it is.  If an option contract has very little or no volume in a particular trading day, however, it does not necessarily mean that the option is illiquid.  Options on stocks do not trade as heavily as the underlying stocks themselves.

What is Open Interest? 

Open Interest is the number of outstanding option contracts in the exchange market or in a particular option class or series.

An options exchange uses open interest to track the number of open and closing transactions in each option series.  Each opening transaction increases the open interest and each closing transaction decreases the open interest.  For example, an order to buy 10 call options to open would increase the open interest for that option by 10.  An order to sell 10 call options to close would likewise reduce the open interest for that option by 10.

In general, the higher the open interest for an option, the greater its liquidity.  The open interest for an option rises as more positions are opened in that contract then there are positions being closed.  This means that an option’s open interest cannot increase unless the trading activity in that option also increases.   An option that has high open interest then must also have a high level of trading activity which in turn increases the liquidity of the option.

The reverse of this situation, however, is not necessarily true.  An option may have little or no open interest simply because it is a new issue.  It takes time for open interest to accumulate and reflect the true liquidity of the option.  Clearly, investors should not use open interest by itself to eliminate an option from consideration just because its open interest is low or at zero.  It is just one of many tools available for identifying potential options to trade.

How do investors use volume and open interest in their trading?

Savvy options investors use volume and open interest to identify liquid options and eliminate illiquid options from consideration.  Liquid options are preferable to illiquid options because the spread between the bid price and the ask price of the liquid option will be narrower.  A narrow bid/ask spread is advantageous because orders will be filled at better prices than if the bid/ask spread is wide.  An illiquid option with a wider bid/ask spread will also require a greater move in the underlying security than a more liquid option with a narrower bid/ask spread for the trade to return a similar profit.  Nothing can be more disheartening to an investor than to be absolutely right about a trade only to have their profit reduced or eliminated because of the illiquidity of the option and the negative impact of its wider bid/ask spread.

Category: Options Trading Basics