guide to option volume and open interest

Tracking stock volume and option volume are two completely different monkeys and special attention needs to be paid to option volume and open interest. When a company releases stock to the market for the first time (initial public offering) it sets the amount of shares it wants to release:

Ferrari SpA (NYSE: RACE) stock starts trading on Wednesday, Oct. 21. The Ferrari IPO plans to raise $860 million by selling 17.2 million shares at a $48 to $52 price range.

The take away when dealing with the Ferrari IPO (Initial Public Offering) is that they plan to release 17,200,000 shares. Unless Ferrari plans to make another secondary offering in the future, stock split or reverse stock split this is the final amount of shares that will be available on the open market.

Options are created on various underlyings constantly and with no limit. This carries with it several advantages such as an infinite amount of choices to trade but also several disadvantages like low liquidity in most options. Not all options are going to be equal. We can use option volume and open interest to sort out the options we want to trade. We are going to look further into option volume, what it means and how we use it. We are also going to define open interest and how it relates to options and how to trade around it and avoid the risk it carries with it.

What Is Option Volume

Option volume is very simple because it is a lot like reading stock volume. Volume is always shown as a daily number. It is the amount of contracts traded at that call or put on that specific strike and expiration.

If The Option Prophet (SYM: TOP) 35 strike puts were traded 3000 times today the volume for the 35 strike puts would read 3000. Tomorrow that volume number would reset back to 0 and increase as more contracts were traded.

It is easy to track stock volume because it is regularly measured and can often be viewed on a chart. Since there are so many options for a single underlying it is often more difficult to keep track. You would have to keep track of each call and put at each strike through multiple expiration dates (tedious). Some brokerages allow you to chart option strikes but it's typically not very helpful if you do.

The reason we care about option volume is because it deals with liquidity. Liquidity is defined by how easy it is to get in and out of a position at the price you want. When trying to trade in an illiquid market it can often be difficult to get a good fill and often times you will have to settle giving you a worse price than you wanted. A highly liquid market means it is quick to get fills at the price you want. In an illiquid market you are often left with a large bid/ask spread. The bid (the price you sell at) and ask (the price you buy at) are the prices you trade at. When these two prices are further apart it puts you in a hole when you place the trade.

If TOP 35 strike puts have a bid of 0.25 and an ask of 0.50 that is a 0.25 spread. That means I begin in the hole $25 as soon as I buy or sell that option.

The more illiquid an option the larger that spread will be. Typically higher volume stocks will have higher volume options. You can also find the more liquid options in near term expirations versus expirations that are further out in time. At-the-money options will be more liquid when compared to out-of-the-money options or deep in-the-money options.

What Is Open Interest

Open interest is a new concept when you first start trading options because it doesn't exist in stock trading. Simply, open interest tracks the amount of open contacts on a specific strike for a call or a put. Like we mentioned previously, option contracts are created on an as needed basis. Unlike stock there is not a set amount of contracts floating out on the market. When a new expiration is created for an underlying all the option contracts start with an open interest of zero.

When a trader buys to open or sells to open an option contract open interest will increase by one. When a trader sells to close or buys to close an option contract open interest will reduce by one. Open interest is not calculated in real-time. Changes occur in open interest after the market closes and can be seen the next day.

While it's not definitive an option with low to zero open interest could signal low liquidity. Options that have expiration dates that are further out in time will have a lower open interest versus near term options. Much like volume, which really go hand-in-hand with open interest, at-the-money options will have higher open interest versus deep out-of-the-money or deep in-the-money options.

While open interest and volume do tell us what strikes the action is happening on it does not tell us if that action is bullish or bearish. A put strike could see its open interest increase by 100 in a day but we do not know if that is because someone bought to open that put (bearish) or sold to open that put (bullish). We also don't know if those options are paired with another play in that trader's portfolio. If calls are sold to open (bearish) are they still bearish if they are covering stock?

The Definition Of Option Pinning

Option pinning is an interesting phenomenon where a stock's price will move to end on a particular option strike. You will only see this happen with a strike has a considerable amount of open interest, at least 2x more than any other strike. This will also only occur on expiration day.

Let's look through an example of why this happens. Imagine being a market maker with a considerable amount of contracts on a certain strike. For this example you are long TOP 100 calls at the 35 strike while TOP is trading at $34.75. What you don't want to happen is for TOP to move above $35 and you get placed 10,000 shares of TOP. As a market maker your not actually looking to take possession of stock. As TOP begins to move towards and above $35 you know you need to hedge your position. You begin to short TOP while its above $35 and as this happens it will begin to reduce the price. Once TOP falls below $35 you can start to buy back your short position thus raising the price.

This can also affect your average trader. If you are also long calls at the 35 strike you may not want to take possession of the stock. At the same time you may not have the same portfolio size or ability to hedge your position by buying and selling the underlying. It is usually best to not hold options so close to expiration. You especially want to be aware when there are candidates for pinning.

What Makes A Good Pin Candidate?

  • High volume underlying stock
  • High volume options
  • Expiration day
  • Strike with double the open interest versus all other strikes at that expiration
  • Large spread between each strike - $5 wide strikes versus $1 wide
  • Monthly expiration dates versus weekly options

Short Straddle

How You Can Profit From Option Pinning

When an option pins it restricts its movement and settles down to an observable dollar amount. To take advantage of this lack of movement and predictability you need to be a net seller of options. Two of the best strategies are short strangles and short straddles. Iron condors can also be used for a lack of movement but you are not going to get any good prices or fills on expiration day and commissions are going to eat away at what you do get. The same could be said about short strangles. The amount of range you get won't be substantial since the premium won't be in the options. Short straddles should be used for maximum profitability. Find the strike you think is going to pin and initiate a short straddle on that strike. If all goes according to plan your two options should expire worthless allowing you to collect your full premium.

Conclusion

There are hundreds of different options out there. Not every option should be traded because it exist. Low liquidity due to a lack of volume and interest will make it difficult to enter and exit a position in a timely manor while receiving a fair price. Options that are closer to the expiration day and closer to being at-the-money will have higher liquidity.

Higher liquidity can bring unwanted circumstances in the form of option pinning. There are two reasons to watch out for option pinning. If you are in a position you need to know if there is potential for a pin. This could affect your position by putting you in or out of the stock when that was not your intention. If you are careful you can also profit from a pin by employing short straddles or strangles. Not every pin candidate will pin but when they do it is an interesting phenomenon.

round testimonial

"Last year The Option Prophet absolutely transformed my trading account from one where monthly gains were often uncertain and unpredictable into one where a steady monthly income stream through OTM credit spreads bought amazingly steady and consistent growth."

-Andrew B. 

growmyportfoliobig