Understanding Option Open Interest

10/11/2011 7:00 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Option volume and open interest are distinctly different concepts, but both are crucial for gaining an understanding of what’s happening in the markets. Here’s how to read and interpret this data.

Volume and open interest are two very important pieces of options data that can help traders understand what is going on in the options market. It is an important part of any trader’s options education.

Volume and open interest help traders make better decisions and can make them more profitable, but to be able to use volume and open interest data, traders must understand exactly what each represents. Let’s take a close look at volume and open interest.

Volume and Open Interest

Volume and open interest are two distinctly different things. Volume is the number of contracts traded in a day. Each day, volume starts over at zero. Open interest is the number of contracts that have been created; i.e. that are open. Open interest is an ongoing, running total.

Volume and Open Interest Example

Imagine it is the day after expiration and a new contract month, the November expiration cycle, is listed for option class XYZ. A trader, Retail Joe, logs into his online retail trading account from home. Retail Joe enters a buy order to buy ten November 65 calls. The order is routed to the exchange and executes with Mark Etmaker, a market maker on one of the US options exchanges.

Because this is the first day these contracts were made available to trade, open interest was zero at the start of the day. Volume is always zero at the start of the day. After the trade is made, both open interest and volume increased: Retail Joe is long 10, and on the other side of the trade, Mark Etmaker is short 10. Therefore:

Volume: 10
Open interest: 10

Now imagine that later that day, a third party trades in the November 65 call series. Tina Trader decides to sell ten calls (maybe as part of a covered call). It just so happens that Mark Etmaker is the market maker who buys the calls from Tina. Notice what happens with volume and open interest.

Volume: 20
Open interest: 10

Because the trade happened the same day, the trade increases volume by the number of contracts traded. But a new contract wasn’t created; it just changed hands. Now, the two parties to the call are Joe and Tina; Mark Etmaker is flat. Therefore, open interest remains the same.

The next morning, volume and open interest is:

Volume: 0
Open interest: 10

Volume starts anew and open interest continues on.

Now, imagine that (coincidentally) Joe decides to sell the ten-lot to close and Tina just so happens to buy hers back at the same time; they trade with each other. Now, both Joe and Tina have no calls—they are flat. Now volume and open interest is:

Volume: 10
Open interest: 0

Ten contracts changed hands; so volume is 10. And the existing contract was closed; so open interest is zero.

By Dan Passarelli of MarketTaker.com

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