Reading Option Volume and Open Interest

Electronic Trading Floor When investors or brokers execute a stock or option trade, these orders are routed to an exchange, such as the New York Stock Exchange (NYSE) or the Chicago Board Options Exchange (CBOE). These exchanges are where all trades (even electronic trades) actually take place.

This fact makes it hard to read the market. But two particular figures – option volume and open interest – can help traders gain insight into what is happening in a particular option series.

Many traders know how to use this information, but a brief review may be helpful.

Volume is a simple measure of how many contracts traded on a particular option. Volume is typically stated as the number of contracts traded each day.

Open interest is how many contracts have been created by traders opening positions. This is a running total. If no option contracts trade in a session, open interest remains the same as the previous session (and volume would be zero).

Example: Volume and Open Interest

The XYZ March 50 calls start trading today. Unlike stock, which sees shares debut the day of its initial public offering, there are not any open contracts when an option starts trading (until an investor places an order) It's not that contracts don't exist, it is simply that there are not any open positions yet at this strike.. So at the opening bell…

Volume is 0
Open interest is 0 (no contracts yet exist)

Later in the day, retail trader Joe sends a brokerage order to buy (to open) one XYZ March 50 call. His order is filled when a market maker (Mark) sells Joe one contract. At this point…

Volume is 1
Open interest is 1 (one contract now exists)

Later that same day, Sarah enters an order to sell (to open) one XYZ March 50 call. The order happens to go to the same exchange, and the same market maker buys one contract from her. Now Joe is long one contract, Sarah is short one contract, and Mark the market maker is flat.

Volume is 2 (two contracts traded today)
Open interest is 1 (there is still only one contract in existence—Joe is long and Sarah is short)

The next day, Joe decides to sell to close his March 50 call. At the same time, Sarah enters an order to buy back her call. Joe and Sarah trade with each other, both closing their positions. After this trade:

Volume is 1 (one contract traded today)
Open interest is 0 (no contracts exist, everyone is flat)

Volume and open interest give definitively different insight into market activity. But when combined, these bits of stock option trading information create a synergy that can provide a more complete story of what market participants are doing (and what their underlying thesis might be).

The higher the open interest, the more positions there are in that option series – plain and simple. The more positions open on an option, the more likely people will be interested in trading it. In other words, the higher the open interest, the more liquid a contract will typically be.

One reason an option might be heavily traded is if news or technicals are in play, boosting awareness and demand. Upcoming earnings, an FDA decision, or a new product launch could increase activity among option traders. Open interest can also indicate higher liquidity because traders who have existing positions will eventually need to act on their position by taking profits or losses — they might have to trade it.

Photo Credit: ralvin

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