Alan Ellman, of TheBlueCollarInvestor.com, explains how option liquidity is measured by Vo(ume) and open interest and why open interest is more reliable, generally, because it is a cumulative stat, not reset to zero each day as is Vol(ume). He also points out the rare exception to the rule.
Check the options chain before selling a covered call or cash-secured put. In addition to determining the premiums and returns we will generate, we also need to make sure the interest or liquidity in these options will be adequate enough for favorable trade executions. Below is a typical options chain showing both Vol(ume) and open interest (OI):
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Note that for the circled strikes (and most of the others as well) the open interest stats are much higher than the Vol stats. The reason is that Vol represents the number of times a particular contract is bought or sold in a particular day. Open interest, on the other hand, represents the number of contracts that are currently outstanding (unexercised, not closed by an offsetting contract, or not yet expired). Open interest stats are cumulative and not reset to zero each day as are Vol stats. Therefore, it makes sense that open interest will always be higher than Vol stats. However, there is one notable exception. Let’s look at the option chain below:
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I highlighted the $16.50 strike with BAC trading at $16.17. In the yellow row we see an open interest of zero but significant Volume of 3,601 contracts. How can that be? This screenshot was taken on February 23, 2015, the first day the March option contracts are the front month or month with the earliest expirations. Additional option strike prices were added this month, specifically ones that ended in 0.50 like the highlighted $16.50 strike price. Early in the trading day there were already $3,601 contracts traded leading to a bid-ask spread of one penny ($0.23–$0.24). So the next question is why is there zero activity in the open interest column and should we avoid these options because of no apparent open interest?
The explanation is that most vendors post open interest stats after market close. Although there are a substantial number of open contracts based on the early volume, we won’t have these stats until the next trading day.
Summary
Option liquidity is measured by Vo(ume) and open interest. Open interest is more reliable, generally, because it is a cumulative stat, not reset to zero each day as is Vol(ume). A rare exception when Vol is greater than open interest is on the first day when contracts become the front month and new strike prices are created for that month. Many vendors will leave the open interest column at zero until the second day when reliable statistics can be gleaned from options chains.
By Alan Ellman of TheBlueCollarInvestor.com
