Why Trading Volume and Open Interest Matter to Options Traders

Price movements in the options market are a reflection of decisions made by traders and investors to buy or sell options contracts. But price isn't the only number that a successful options trader keeps an eye on.

Daily trading volume and open interest are two other important figures to watch. Understanding these technical analysis metrics can help you make better-informed investment decisions.

Daily Trading Volume

Trading volume refers to the number of options contracts traded in a given period of time, such as a trading day. Every transaction, whether a purchase or sale of an option, becomes part of the daily volume figure.

Daily trading volume can give you insight into the strength of a current price movement as well as investor demand and liquidity. It's a technical indicator of current interest.

However, trading volume is relative and should be viewed over time to obtain an understanding of trader interest and liquidity. It can also 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 that matches the direction of the change. But, a big increase in price accompanied by low trading volume does not necessarily signify price strength. In fact, that combination may well indicate that a price reversal is coming soon.

That's why, in combination with open interest, trading volume can be used to anticipate price movements and help traders set entry and exit points.

Open Interest

Open interest refers to the number of active options contracts that are held by traders and investors. These are positions that haven't been closed out by an offsetting trade or an exercise or assignment.

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 open interest, which can lead to unforeseen consequences.

Open interest is determined after a trading day ends and is the difference between open positions and those closed. It is calculated for the life of the options contract.

When you buy or sell an option, you are either opening a position or closing it. If you buy 10 calls on ABC stock, that purchase opens a position. (Each call represents 100 shares, so that's 1,000 shares in total.) Therefore, your trade adds 10 to the open interest figure. If you close out that position by selling those same options, open interest would then fall by 10.

Selling an option can also add to the open interest. Say that you owned 1,000 shares of ABC and wanted a covered call position. You'd place a trade order to sell 10 calls. Once filled, that opens a new active position and adds 10 to the open interest. If you later bought back those 10 options, that would close out your active position and open interest would decrease by 10.

Why Trading Volume and Open Interest Matter

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 may be why many options traders ignore open interest altogether. At first glance, they may not realize the information that it can indicate on its own and in combination with trading volume.

Trader Interest

One way to use open interest is to look at it relative to the trading volume of contracts. When the volume exceeds the existing open interest on a given day, it suggests that trading in that option was exceptionally high. And if the price rose, that can indicate investor demand, which can prompt traders to consider what's driving that demand and the degree to which it will affect the price.

Liquidity

Open interest also gives you key information about the liquidity of an option. If there is no open interest in (or demand for) an option, there will be no secondary market for that option and it could be hard to buy or sell. Options with significant open interest point to a large number of open, active positions.

Substantial volume along with that can reinforce the view of activity and liquidity. An active secondary market increases the odds of efficient pricing and getting option orders filled at good prices.

The greater the open interest and trading volume, the easier it will be to trade that option at a reasonable spread between the bid and ask.

Example

For example, suppose you look at options on shares of Apple Inc. and see that the open interest on a particular options contract is 12,000. Trading volume is high as well. This suggests that the market in that options contract is active, there's demand, and there may be a lot of investors 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 one, meaning there is only one open position in that contract. This indicates a lack of demand and no secondary market due to few interested buyers and sellers. There's no liquidity. It would be difficult to enter and exit a position in that option at a good price.

The Bottom Line

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