Why Open Interest and Trading Volume Matter to Options Traders

Price movements in the options market are a reflection of decisions to buy or sell options made by millions of traders. But the price isn't the only number that a successful options trader keeps an eye on. Daily trading volume and open interest are two additional key numbers to watch when trading options. Understanding these two numbers can help you make better-informed investment decisions.

Daily Trading Volume

Trading volume is the number of shares or contracts traded in a given period. When looking at the option's underlying stock, the volume can give you insight into the strength of the current price movement. Trading volume in options, just like in stocks, is an indicator of the current interest.

However, trading volume is relative. It needs to be compared to the average daily volume of the underlying stock. A significant change in price accompanied by higher-than-normal volume is a solid indication of market sentiment in the direction of the change. But, a big increase in price accompanied by low trading volume does not necessarily signify strength. In fact, that combination may well indicate that a price reversal is coming soon.

Open Interest

Open interest is the number of active contracts. It's one of the data fields on most option quote displays, along with bid price, ask price, volume, and implied volatility. Yet, many options traders ignore active contracts, which can lead to unforeseen consequences.

Open interest indicates the total number of option contracts that are currently out there. These are contracts that have been traded but not yet liquidated by an offsetting trade or an exercise or assignment.

When you buy or sell an option, the transaction is entered as either an opening or a closing transaction. If you buy 10 calls from ABC, you are buying the calls to open. (Each call represents 100 shares, so that's 1,000 shares in total.) That purchase will add 10 to the open interest figure. If you wanted to get out of the position, you would sell those same options to close. Open interest would then fall by 10.

Selling an option can also add to the open interest. If you owned 1,000 shares of ABC and wanted to do a covered call by selling 10 calls, you would be entering a sale to open. Since it is an opening transaction, it would add 10 to the open interest. If you later wanted to repurchase the options, you would enter a transaction to buy to close. Open interest would then decrease by 10.

Why Open Interest Matters

When you are looking at the total open interest of an option, there is no way of knowing whether the options were bought or sold. That's probably why many options traders ignore open interest altogether. However, you shouldn't assume that there's no important information there.

One way to use open interest is to look at it relative to the volume of contracts traded. When the volume exceeds the existing open interest on a given day, it suggests that trading in that option was exceptionally high that day.

Open interest also gives you key information regarding the liquidity of an option. If there is no open interest in an option, there is no secondary market for that option. When options have a significant open interest, it means there are a large number of buyers and sellers out there. An active secondary market increases the odds of getting option orders filled at good prices.

All other things being equal, the bigger the open interest, the easier it will be to trade that option at a reasonable spread between the bid and ask.

For example, suppose you look at options on Apple Inc. and see the open interest is 12,000. This suggests that the market in Apple options is active and there may be a lot of investors in the marketplace who want to trade. The bid price of the option is $1 and the offer price of the option is $1.05. Therefore, it is likely you can buy one call option contract at the mid-market price.

On the other hand, suppose the open interest is 1. This indicates there is very little open interest in those call options and there is no secondary market because there are very few interested buyers and sellers. It would be difficult to enter and exit those options at good prices.

The Bottom Line

Trading does not occur in a vacuum. Indicators that show you what other market participants are doing can inform your trading system. Daily trading volume and open interest can be used to identify trading opportunities you might otherwise overlook. These indicators are also useful for making sure the options you trade are liquid, allowing you to easily enter and exit a trade at the best possible price.