What is Options Trading Volume?
Trading volume and open interest are like the pulse and blood pressure of the options market. They give option traders vital signs about the health and direction of market activity. Trading volume refers to the number of option contracts exchanged during a given period, typically one trading day. Open interest, meanwhile, is the number of outstanding contracts that haven't been settled.
Together, these measures offer clues about the strength of trends, the likelihood of price reversals, and the ease with which positions can be entered or exited. As we explore below the significance of these metrics, we'll see how they can be leveraged to make better trading decisions and potentially improve your returns.
Key Takeaways
- Daily options trading volume is the number of options contracts bought and sold on a particular day.
- Open interest is the number of open positions in options contracts.
- Together, they provide a better understanding of a particular option's liquidity, demand, and price moves.
- The greater the open interest and volume, the better the liquidity and efficiency of pricing.
- Trading volume is reset daily; open interest is calculated continuously over the life of the option.
Understanding Options Trading Volume
Each options transaction, whether a buy or a sell, contributes to the daily trading volume count. This metric is a significant indicator of the activity and liquidity of the options market for a particular security. Here is how options trading volume is used:
- Liquidity indicator: The daily trading volume is a primary indicator of options' liquidity. Higher volumes often mean the option contract is more liquid, making it easier for investors to enter or exit positions at their desired price levels. A higher trading volume can also lead to narrower bid-ask spreads, reducing the cost of trading.
- Market sentiment: Analyzing daily trading volume can also provide insights into market sentiment. For instance, a sudden increase in trading volume might indicate that a new trend is starting, while decreasing volume could signal a potential reversal or the end of a trend.
- Volatility measurement: Increased daily trading volume can also be associated with higher volatility, especially if significant news or events are driving a large number of traders to buy or sell options contracts.
- Confirmation of price movements: Volume analysis is often used with price analysis and other indicators to confirm trends and chart patterns. For instance, an upward price shift with an increase in volume is often viewed as a stronger bullish (positive) signal compared with an upward movement with decreased volume.
- Historical comparison: Investors and analysts often compare the present daily trading volume with past volume levels to gauge the relative activity in the options market. This provides a context for interpreting the present volume levels.
- Institutional activity: Large trading volumes can sometimes indicate institutional activity, which may reflect professional opinions about the direction of the underlying asset's price.
Why Is Trading Volume Important to Traders?
Trading volume helps traders understand market dynamics, liquidity, and potential prospects in securities. High trading volume for an option indicates strong market sentiment, but it can be either bullish or bearish, so you'll need more information to see which.
In addition, a higher volume typically means better liquidity, allowing for easier entry and exit from positions, cutting trading costs with narrower bid-ask spreads. Also, a spike in trading volume generally precedes significant price shifts, making it helpful in determining volatility. Traders closely monitor volume to capitalize on these movements.
Volume can also be used to confirm the validity of market trends, such as breakouts or reversals, and can help prevent traders from falling for false signals when volume is low during price movements. Finally, traders look to options trading volume to develop and refine their tactics, employing volume-based indicators to help identify the best entry and exit points while managing risk.
High trading volume doesn’t always mean a strong trend. Sometimes, it can signal indecision as buyers and sellers clash, leading to a potential reversal.
What Is Options Open Interest?
Open interest is the number of outstanding options contracts traded but not yet liquidated or closed by either an offsetting trade, exercise, or assignment. As a measure of liquidity in options markets, it is the number of contracts that are still active.
Open interest increases when a new option order is executed and a new contract is added to the option chain. It's lowered when an existing option contract expires, is exercised, or is closed through an offsetting trade. High and rising open interest suggests the option has active trading and interest, while a decline in open interest means traders are closing out positions (meaning a reduction in interest). More specifically, high open interest in call options signifies a bullish sentiment, while high open interest in put options suggests a bearish sentiment.
Open interest is tracked separately for call and put options.
Here's how you can use open interest in your trading:
- Liquidity indicator: A higher open interest reveals there's more liquidity for the options contract. This liquidity makes it easier for traders to enter or exit positions at fair market prices.
- Market sentiment: An increase in open interest might indicate new money coming into the market, suggesting that the trend is likely to continue. Conversely, a decrease in open interest can signal that the market is liquidating or a coming change in market direction.
- Support and resistance levels: Some traders analyze open interest at different strike prices to identify where the market may find support or resistance levels. High open interest at a particular strike price can serve as an area of resistance or support.
- Hedging and managing risk: Institutional investors and fund managers often use options open interest data to plan hedging strategies that protect portfolios against adverse price moves.
- Trading strategies: Options traders might use open interest to find potentially profitable trading opportunities. For example, they might look for options contracts with high open interest and volume since they can be easier to trade.
Why Is Open Interest Recorded?
Recording open interest ensures transparency in the options markets and shows they are still running smoothly. Open interest provides an appreciation for present and historical market activity, liquidity, and market sentiment. Participants can see the depth of the market, confirm trends, manage risk, and anticipate potential areas of volatility.
In addition, open interest helps regulators and participants monitor for market manipulation, boosting market integrity. Open interest also serves as inputs for many derivative pricing models market participants use.
How Does Open Interest Work?
Open interest increases when new contracts are created and decreases when existing positions are closed. Closing positions are typically when traders and market participants sell their contracts, exercise options, or let them expire.
In addition, open interest remains unchanged if a contract is transferred from one entity to another without closing any position. Exchanges report this data daily, reflecting the number of outstanding contracts at the close of each trading day.
How To Use Open Interest in Trading
Experienced traders use open interest to assess market sentiment, liquidity, and trend strength, which helps them refine their trading strategies. By analyzing open interest alongside price movements, traders can gauge whether the market is leaning bullish or bearish, with rising prices and increasing open interest often indicating strong bullish sentiment. In addition, experienced traders prefer options with high open interest for better liquidity, allowing for smoother entry and exit positions with minimal impact on prices.
Another use for open interest is to confirm trends and identify potential reversals. For example, increasing open interest with strong price movements suggests that the trend is likely to continue, while decreasing open interest may signal a weakening trend. Moreover, traders monitor open interest at specific strike prices to identify support and resistance levels, particularly when the expiration date approaches, where sizeable open interest can lead to significant price movements.
Combining open interest with trading volume can offer a clearer picture of market dynamics, helping traders confirm breakouts and anticipate volatility. Strategically, open interest can be used during expiration and around significant market events when traders anticipate price movements and adjust their positions accordingly.
Illustration of Options Volume and Open Interest
Above is the options chain for Tesla, Inc. (TSLA) with an expiration date of Sept. 6, 2024. The chain comprises call and put options with various strike prices ranging from $75 to $212.50. Also included are the last traded price, price change, bid and ask prices, trading volume, and open interest for each option.
At the time of this chain, call options showed large declines in last traded prices, while put options display mostly positive changes, indicating potentially bearish sentiment. The open interest and volume data suggest varying levels of activity across different strike prices, with some strikes showing high engagement, particularly in strike prices for $190.00 to $202.50 and above.
Example of Options Volume and Open Interest
Let's drive these ideas home with a hypothetical scenario involving an imaginary company called TechFlow Inc. (fake ticker: TFL). Suppose it's trading at $100 per share, and you're interested in buying the $105 call option (options that become profitable when the price of TFL rises above $105) expiring in one month.
Now, you look at the options volume and open interest to get a sense of market sentiment and activity around these options:
- Today, you notice that the trading volume for the TFL $105 call options is 500 contracts when the normal average volume is less than 50 contracts. The high volume reveals a significant amount of new trading.
- You also see that the open interest for the TFL $105 call options is 2,000 contracts, which has grown steadily over time from under 100 contracts. This suggests that there are now 2,000 open contracts that have not been exercised, closed, or expired.
Analyzing these figures reveals the following:
- Increased activity: The high volume of 500 contracts traded in a day compared with previous days indicates a growing interest in TFL stock, possibly because of a recent positive earnings announcement or favorable market news about the tech sector.
- Sustained interest: The open interest of 2,000 contracts indicates a sustained interest in these specific options, which could indicate ongoing bullish sentiment among investors expecting the price of TFL to rise above $105.
- Good Liquidity: The increase in open interest also suggests rising liquidity for the TFL $105 call options, making it easier to enter or exit positions at desirable prices.
Based on this data and other research, you buy some TFL $105 call options, anticipating the price to go up. The high volume and open interest could be a positive sign, suggesting that other market participants might also expect TFL's stock price to rise. Over the next few days, you continue to monitor the volume and open interest. If the volume and open interest continue to rise along with TFL's stock price, that will reinforce your bullish outlook. Conversely, you'll reevaluate your position if the volume and open interest decline.
In this scenario, the volume and open interest work together to provide a clearer picture of market sentiment regarding TFL's potential price movement. A high trading volume coupled with substantial open interest suggests a heightened activity and a sustained interest in the TFL $105 call options. By analyzing both metrics together, you help confirm the prevailing market sentiment, which bolsters your confidence in deciding on the TFL $105 call options.
How Can an Option Have Volume But no Open Interest?
Volume resets daily, but open interest carries over. If an option has volume but no open interest, it means that all open positions were closed in one trading day.
Is Open Interest a Good Indicator?
Rising open interest shows an increase in activity, while falling open interest reveals that traders are closing their positions.
Should Volume or Open Interest Be Higher?
It depends. Volume can be higher than open interest on a given day. Volume resets each trading day, while open interest carries over. When trading volume is higher than open interest, this usually indicates that traders are closing positions (which reduces open interest).
The Bottom Line
Trading does not occur in a vacuum. Indicators that show traders what other market participants are doing can help you discern where a stock price might be headed. Daily trading volume and open interest can be used to identify trading prospects that you might otherwise overlook.
These indicators are also useful for making sure that the options that are traded are liquid, allowing you to easily enter and exit a trade at the best possible price.
