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Volume and Open Interest are similar in that they show the level of buying and selling underlying a potential price move in options and futures. Understanding these two metrics can give traders a deeper insight into what is happening with options/futures contracts and can assist in ultimately making better informed decisions.
In this article, we’ll guide you through the answers to our initial questions as well as explain the differences and offer tips on how to use volume and open interest to further your trading success.
So first things first, as both Volume and Open Interest are metrics used to describe liquidity, we’re going to begin our discussion with the importance of Liquidity in Options Trading.
Every transaction needs a buyer and a seller. When there are large numbers of buyers and sellers participating in the market, it is generally easier to get in and out of positions as there are many other traders waiting on the sidelines to buy from and sell to. This in essence is liquidity - the ability to move in and out of a position with ease.
When there is high volume of trades taking place, this is a good indication of high liquidity in the asset. This results in better order execution, minimal slippage, and more risk control as traders are in a far superior position to close trades and walk away with realized profits.
Where options do not have high liquidity, traders can find themselves either trapped in a bad position or unable to take out a position large enough to make the trade worthwhile.
Take for example, an option contract that is so far in-the-money (ITM) - the premium for the contract alone would be so high it would exclude a huge portion of buyers from purchasing the option. For contracts so far out-the-money (OTM) - there is greater likelihood of the option expiring worthless. Buyers aren’t generally interested in throwing their money at an almost guaranteed losing trade.
Same goes with time - a contract that has greater than 12 months to expiration isn't going to have as many interested parties as contracts expiring in two months.
Options trading is a balancing act. Not only do you have to consider price action, premium, time, and volatility; you also need to ensure that there is sufficient liquidity to be able to move in and out of positions. To assess liquidity, traders look to Volume and Open Interest.
Volume is the total count of transactions - this means all the opening and closing transactions of a particular options contract. It is a measure of market activity.
Open Interest is the total number of open transactions - this means all contracts that have not been exercised, closed or allowed to expire. It is a measure of market participation.
You will normally find the values of both Volume and Open Interest in an Options Chain (Options Matrix).
Options Chain/Options Matrix
When you go to purchase an options contract on an online stock trading platform, you will need to open the Options Chain. This is a matrix of all the available option contracts for a given stock or future.
The Options Chain displays all contracts according to expiration date and strike price and further provides a range of metrics including bid, ask, last etc.
As the sheer amount of data can be overwhelming to new traders, we give you a rundown of some of the key metrics below. The Greeks are also important and we provide a thorough explanation of them in a previous article here.
Last - The last transacted price, usually delayed by 15 mins.
Change - Change in options price since yesterday’s close.
Bid - Highest price a trader is willing to buy.
Ask - Lowest Price a trader is willing to sell.
Volume - The amount of contracts traded during the day so far.
Open Interest - The number of contracts currently open in the market as of close yesterday.
Volume is the measure of how much a financial instrument has been traded in a particular day. For Options and Futures, volume measures the number of contracts that have changed hands regardless of whether it’s an opening or closing transaction.
Volume makes prices move. It is such a strong force behind the markets that traders will often look to volume as a significant indication of overall market strength and the strength of a specific financial asset. The greater the volume, the greater the liquidity, and the greater the number of buyers and sellers interested in that particular instrument.
The relationship between volume and price goes like this:
Coordination equals a bullish signal and Divergence equals a bearish signal.
To further explain:
Where volume and price move in the same direction either up or down, this is a bullish sign. When they both move up, this represents an increase in buying pressure caused by an increase in the number of transactions that will likely continue to keep pushing the price up in the short term. When they both move down, this represents a lack of conviction in falling prices and is a signal of a likely price reversal to the upside.
However, if there is divergence between the volume and price trends, this a bearish sign. When price is rising and volume is falling, this represents a lack of conviction in the rising prices and is a signal of a likely price reversal to the downside. When price is falling and volume is rising, this represents an increase in selling pressure that will likely continue to keep pushing the price down in the short term.
How do you calculate volume in options?
Volume is calculated by adding all the opening and closing transactions of a particular options contract. Take for example, if 3 Traders (Trader 1, Trader 2, Trader 3) are trading a particular contract and:
Trader 1 enters into a long trade by buying 5 contracts;
Trader 2 enters into a long trade by buying 10 contracts;
Trader 3 enters into a short trade by selling 1 contract; and
Trader 1 exits their trade by selling their 5 contracts;
The volume for that particular contract would be 21 as you take the sum of all the open and closing contracts.
While it’s good to know how to calculate volume to appreciate the difference between volume and open interest, it’s easy to find the data on all online trading platforms. Trading Volume is often shown in the option chain or on vertical bars or histograms plotted on the stock chart. Each bar shows how many shares or contracts have changed hands over a certain period of time. The taller the bar, the higher the volume. While a shorter bar shows lower volume. The bars are also typically color coded red or green, where:
Red is Selling Volume. The price has declined during the time period.
Green is Buying Volume. The price has increased during the time period.
For more of a discussion on Volume and volume trading analysis, check out our article on On Balance Volume Indicator.
Open Interest is the measure of activity in a particular options or future series. It represents the number of existing open contracts for each option strike price, put, and call. Open Interest differs from Volume as it only represents open contracts: ie. those that have not been closed, exercised or expired. Where contracts are closed or liquidated, these contracts are removed from the Open Interest value. Because of this, Open Interest is a good indication of whether money is moving in or out of an options contract. An increase in Open Interest means new money is moving into the options contract. While a decrease in Open Interest means that money is leaving that options contract.
However, Open Interest is not updated on a trade-by-trade basis. Rather, as the values for open interest are transmitted from exchanges, it’s value represents the previous day's reconciliation of transactions as per the exchanges reporting requirements with the Options Clearing Corporation.
To best ensure that your options have enough liquidity to allow you to freely move in and out of positions, try to avoid entering contracts with an open interest less than 500.
How do you calculate open interest in options?
Open Interest is calculated by adding all the opening and subtracting all the closing transactions of a particular options contract. Take the same example above where 3 Traders are trading a particular contract:
Trader 1 enters into a long trade by buying 5 contracts - Open Interest increases to 5
Trader 2 enters into a long trade by buying 10 contracts - Open Interest increases to 15
Trader 3 enters into a short trade by selling 1 contract - Open Interest increases to 16 and;
Trader 1 exits their trade by selling their 5 contracts - Open Interest decreases to 11 as the trade has now closed.
Open Interest, Volume and Price
Similar to volume the relationship between Open Interest and Price goes along these lines: when price and Open Interest move in the same direction (ie. up or down) this represents a bullish signal. When Price and Open Interest move in opposite directions this is a bearish signal.
However, what does it mean when Open Interest and Volume do not move in the same direction? We take a closer look at this below.
When Open Interest is higher than Volume
You will come to notice that Open Interest will almost always be higher than Volume. The reason for this is that Volume represents the number of times an options contract has been traded in a particular day. This means that at the start of the trading day, the value for volume is reset to zero.
Open Interest, on the other hand, represents the cumulative total of all open contracts. It does not reset to zero. Hence, trading volume will generally be much less than the cumulative total of contracts currently open.
When Volume is higher than Open Interest
However, there are occasions when Volume exceeds Open Interest. When this happens it means that trading on that particular day was exceptionally high which is generally spurred on by new interest from some kind of catalyst. Where Volume is much higher than the Open Interest, you can generally infer that parties are opening positions. Since Open Interest data is reconciled at the end of the day, the new open contracts will only be reflected in the Open Interest value the following day.
Understanding Options Flow
Options Flow data can also provide information regarding Volume and Open Interest. We provide a brief explanation of how to read the options flow below.
Section 1 - This is the range of the days of option activity. Generally, for the weekly reports, this date range is defaulted to Monday to Friday of the previous week. This filter is applied across the entire report.
Section 2 - This section outlines the distribution of overall calls and puts. Lighter shaded area (Unusual) is the volume of calls/puts where volume has exceeded open interest. If the lighter shaded area expands over 50%, it means that there is new interest spawning up in calls/puts. When looking at options flow, this parameter helps us in gauging conviction in a trend shift or continuation of the underlying.
Section 3 - There are two gauges which are depicted here. One shows conviction of bulls on the volume side and the other, conviction of bulls on the premiums they are willing to pay. Essentially, over 50% on both these gauges is a good indication of overall bullishness in the flow.
Section 4 - This section shows the overall premiums traded by big money across calls or puts. Based on this, we can gauge which side of the options chain is liquid compared to the other. Higher the difference, better is the liquidity on that side of the options chain.
Section 5 - This shows the distribution of the volume of calls/puts by the side of the execution. Ask volume denotes going LONG and Bid volume denotes going SHORT. Mid prices are usually, the trades in between and hence not very important in the bigger picture.
Section 6 - This section shows the distribution of the calls/puts by volume, strike and expiry. It gives us a quick look at the strikes that have the highest volume compared to the others and across multiple expiries. Based on the example, we see the highest volume of call strikes around 3300 for Nov expiry.
Section 7 - In this section, we see highest volume strikes and expiry of calls and puts. A day's trades are combined for a particular strike and expiry and then compared against open interest. Premiums are also shown to see how much the overall trades have been traded for.
Section 8 - The volume of the above transactions are color coded to see the net impact of the trades on the options strikes. For calls, Brightest green shows trades on the underlying options are net LONG and brightest Red shows trades on the underlying options are net SHORT. Conversely, for puts, Brightest green shows net SHORT and brightest red shows net LONG. Simply put, more green is more bullishness.
Section 9 - This section is a summary of the Underlying Stock. Some general performance metrics along with earnings and a market rating of the underlying
Pay Less For Liquidity
What happens if you ignore Volume and Open Interest? Well, if you happen to enter a contract with low Volume and Open Interest this could translate to higher costs. Why? Liquidity saves you money.
Where the Market Bid is the highest price a trader is willing to buy and the Market Ask is the lowest price a trader is willing to sell, the difference between the two is what we refer to as Spread. When liquidity is low (ie. Volume and Open Interest is low) the spread widens. When you buy an options contract on the market ask price and immediately sell on the market bid price, you will have an immediate loss - this is what we refer to as Slippage. The wider the spread, the greater the slippage, and the greater the loss.
Volume and Open Interest give traders an extra edge. Pay attention to them to prevent being trapped in a bad trade.
Choosing Strike Price
Volume and Open Interest provide helpful insight into which option strikes to trade. Where there are large clusters of open interest and volume around certain strike prices, this can be interpreted as potential trading opportunities. However, never just enter a trade to follow the crowd!
Use these strike prices as the starting point to begin your own analysis. Mark your charts, research the stock, and check whether there are earnings or other catalysts on the horizon to support the strike price. Most importantly, follow your trading plan and make sure the trade checks all of your boxes.
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