When buying or selling stocks, liquidity is an essential factor. Illiquid stocks can be challenging to acquire or unload for a reasonable price. For example, you won't get the full allotment you desire if you want to buy 100 shares of a particular stock, but only 60 shares are available on the open market. Options trading also requires paying attention to market liquidity, but with multiple contracts available for the same stock, other variables come into play. As a result, options traders must understand two similar but distinct concepts: option volume versus open interest.
What is option volume?
When trading stock options, each security will have multiple contracts with various strike prices and expiration dates. Having a multitude of contracts trading based on the same underlying security naturally creates variations in the availability of these contracts.
Option volume refers to the total number of contracts at a particular strike price and expiration that have exchanged hands during a trading session. While the underlying stock might have a share volume in the thousands or even millions, options on that security will have varying volume levels for each contract.
Option volume tends to be higher in contracts with a strike price close to the underlying stock price.
Disclaimer: Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
How to calculate trading volume?
To determine the trading volume of a particular options contract, add all the transactions occurring in that market on the current trading day. Transactions going both ways are tallied into the volume total, meaning that opening and closing trades are factored into the equation.
Much like shares of stock, options contracts can be traded multiple times per day, so the volume could be much higher than the total number of open contracts.
How do investors interpret trading volume?
Options volume is helpful because it gives investors a clue about the total liquidity in that specific market. When many contracts exchange hands daily, the market likely has sufficient liquidity for more efficient pricing and narrower bid-ask spreads. This can also help lower the possibilities on partial buy or sell orders from filling.
Option volume example
One of the most popular stocks for options is Apple Inc. (NASDAQ: AAPL). If you’re looking for a highly liquid options market on AAPL stock, you might consider two different strike prices with the same expiration date.
For example, suppose you want to buy a call option on AAPL with an August expiration. The contracts with the $180 strike price have a daily trading volume of 94,000, while the $165 strike calls only have a daily volume of 4,500. So which market is more liquid? The $180 calls, which is where you might want to focus your attention.
What is open interest?
Unlike volume, open interest isn’t a tally of transactions but a tally of the total number of contracts currently open and held by investors. For example, if an options market has an open interest of 3,000, that means 3,000 contracts are presently held in investors' brokerage accounts.
When a contract is closed, expires, or is exercised it’s removed from the open interest total.
Disclaimer: Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
What do high and low open interests mean?
Like volume, high and low open interest can determine a market's liquidity and enthusiasm. But unlike volume, open interest only refers to the number of currently open contracts.
When open interest is high, new money is flowing into the market. When open interest declines, contracts are settled, and cash flows out of that market.
How do investors interpret open interest?
Open interest tells investors about the liquidity and money flow entering specific options markets, which can be used as an indicator for both options and stock trading.
For example, if open interest is high in a call option with a strike price above the current market price of the underlying, it could be interpreted as a bullish signal.H3: Open interest example
Here’s an example of using open interest to inform a trading decision: You’re looking at two similar AAPL call option contracts, one with a strike price of $180 and an August expiration and one with a strike of $190 with a July expiration.
The $180 strike option has an open interest of 3,000, but the $190 strike has an open interest of 9,000. What does this mean? Because more money is flowing into the $190 call option market that’s closer to expiry than the $180 call option market, it could signal that investors are anticipating a robust and short-term move upward in the underlying AAPL shares.
What is the importance of liquidity?
Liquidity is the oil that greases the gears of the market. Without liquidity, the market would seize up like an engine without lubrication, preventing orders from filling. Illiquid markets are full of risk and could lead to investor mistakes.
With an illiquid market, you may be unable to sell your assets when you want or at the price you desire. Plus, illiquid markets increase bid/ask spreads because facilitating trading is challenging when volume and open interest are low.
But when liquidity is high, buyers and sellers frequently engage in transactions, which can help reduce volatility risks and lowers bid/ask spreads. The more liquid a particular market is, the easier it will be to trade more efficiently.
Like stocks, options must have ample liquidity to facilitate trading
Volume and open interest are two vital statistics that options traders need to consider when making investments. When these two numbers are high in a particular options market, it tells investors the market is liquid and flush with capital. But if these figures are low, it could indicate illiquid markets with money moving out to other areas. If you want to learn about trading options, familiarize yourself with these concepts.
Options traders often ask the following questions regarding open interest and volume. Be sure to understand these concepts before opening any positions.
- How can an option have volume but no open interest?
Open interest only refers to contracts that haven’t been exercised or closed. So, for example, if only closing trades are made, the options market will have volume but no open interest because all contracts have been settled.
- Why is higher volume better in options?
Higher volume means investors are taking an interest in a specific market, which can lower trading costs and the risk of a partial order fill by increasing liquidity.
- Is it good to have a high open interest in options?
Yes, in general, high open interest means that new contracts are being opened, indicating that capital is entering the market.
