As covered call writers, we have all looked at option chains. That's where we determine how much cash will be generated into our accounts when we sell our options. It's fun! We first inspect the current price of the underlying security (stock or ETF). Then we check out the closest strike prices (I-T-M, A-T-M and O-T-M) and take note of the bid and ask prices. For I-T-M strikes, we will also look at the amount of intrinsic value that the option premium consists of. If we are interested in a particular option, we will make note of the option symbol, usually found to the left. Let's look at a typical options chain for a stock Mercadolibre, Inc. (NASDAQ:MELI) an equity that was in my portfolio at one time (note the original option symbology):
Options Chain for MELI
Current market price: $48.59
I have highlighted two columns that tend to be overlooked, Vol(ume) and Open Interest. Although many investors assume these stats are similar, they are, in fact, quite different. The purpose of this segment is to discuss that distinction and the significance of each figure.
This is a measure of the number of transactions that transpired for a particular options contract for that day. It signifies how many times a day a particular contract has been bought or sold. The higher the volume, the greater the liquidity. A contract with zero volume should NOT be considered illiquid because it takes time to build up volume during the day. Also, an exchange specialist or market maker will step in to take the other side of the transaction. On the above options chain, the volume for the O-T-M $50 call is 202 contracts bought or sold thus far that day.
This is the number of option contracts that are open or outstanding on a particular day. This number is cumulative. Options with large open interest have a secondary market of buyers and sellers. This will allow that option to be traded at a reasonable bid-ask spread. The open interest for the $50 strike on the above chart is 2282 contracts.
The Mathematics of open Interest:
There are four types of options trades that can be executed (see the chart below):
Mathematics of Vol and Open Interest
Two will increase open interest and two will decrease it:
Buy to Open (BTO) - Increases open interest by creating a new long position
- Sell to Open (STO) - Increases open interest by creating a new short position
- Buy to Close (BTC) - Decreases open interest by closing an existing short position
- Sell to Close (STC) - Decreases open interest by closing an existing long position
Trading Activity and Open Interest:
|TRADING ACTIVITY||CURRENT OPEN INTEREST||VOLUME|
|Trader A: B-T-O 6 contracts||6||6|
|Trader B: B-T-C 2 contracts||4||8|
|Trader C: S-T-O 8 contracts||12||16|
|Trader D: S-T-C 3 contracts||9||19|
Mathematics of open interest
As you can see, open interest is not the same as volume. With volume, both entries and exits cause volume to increase but in the case of open interest, entries will cause an increase and exits a decrease in open interest. Open interest is generally a higher number than Volume because it is cumulative whereas volume is reset to zero at the beginning of each trading day.
Significance of Open Interest:
Increasing open interest shows strength in the current price movement of an option in much the same way as a volume spike will enhance the significance of a change in a technical indicator like the MACD. Decreasing open interest shows a weakening of the current price movement. If the price is increasing on increasing open interest, the likelihood of continued price increases is greater. If open interest starts decreasing, that upward price movement is starting to weaken. Also, as mentioned earlier in this chapter, the greater the open interest, the more favorable the bid-ask spread is likely to be. Open interest of 100 contracts or less is thought to have relatively thin liquidity. I like to see an OI of at least 100 contracts and/or a reasonable bid-ask spread ($.30 or less). Keep in mind that a bid-ask spread of greater than $.10 can oftentimes be negotiated down by "playing the bid-ask spread" or setting your price slightly below the midpoint of the spread.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.