Open interest and bullishness – Option Trading FAQ

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Open interest and bullishness

Q: Does an increase in open interest imply a bullish sentiment?

A: The open interest only represents the total number of option contracts for a particular option series which have been opened but not yet closed out. For every open contract there is a buyer and a seller. Let’s suppose we are talking about call options. When a new contract is establish, there is a buyer (bullish) and a seller (bearish). So if there is 100 new open contracts, there will be 100 bullish buyers and 100 bearish sellers. Since the number of bullish and bearish positions are equal, this indicates neither a bullish or bearish outlook.

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Using Open Interest to Find Bull/Bear Signals

Open interest is an indicator often used by traders to confirm trends and trend reversals for both the futures and options markets. Open interest represents the total number of open contracts on a security. Here, we’ll take a look at the importance of the relationship between volume and open interest in confirming trends and their impending changes.

Volume and Open Interest

Used in conjunction with open interest, volume represents the total number of shares or contracts that have changed hands in a one-day trading session in the commodities or options market. The greater the amount of trading during a market session, the higher the trading volume. A new student to technical analysis can easily see that the volume represents a measure of intensity or pressure behind a price trend. The greater the volume, the more we can expect the existing trend to continue rather than reverse.

Technicians believe that volume precedes price, which means that the loss of either upside price pressure in an uptrend or downside pressure in a downtrend will show up in the volume figures before presenting itself as a reversal in trend on the bar chart. The rules that have been set in stone for both volume and open interest are combined because of their similarity; however, there are always exceptions to the rule.

General Rules for Volume and Open Interest

The basic rules for volume and open interest:

Open Interest vs. Volume: What’s the Difference?

Open Interest vs. Volume: An Overview

Volume and open interest are two key measures that describe the liquidity and activity of contracts in the options and futures markets. However, their meanings and applications are different. Volume refers to the number of contracts traded in a given period, while open interest denotes the number of contracts that are open or active. Here’s a more detailed look at the two measures and how investors can use them to understand trading activity in the derivatives markets better.

Volume

Trading volume is updated throughout the trading day and measures the number of options or futures contracts being exchanged between buyers and sellers, identifying the level of activity for that particular contract. For every option that is bought and sold, the transaction itself counts toward the daily volume, regardless if the trade is an opening or closing transaction.

Key Takeaways

  • Volume and open interest both describe the liquidity and activity level of contracts in the options and futures markets.
  • Volume refers to the number of trades completed and is, therefore, a key measure of strength and interest in a particular trade.
  • Open interest reflects the number of contracts that are held by traders and investors in active positions, ready to be traded.
  • While volume is running total throughout the trading day, open interest is updated just once per day.

For example, assume the volume in call option ABC with a strike price of $55 and an expiration date in three weeks did not trade any contracts on a specified day. Therefore, the trading volume is 0. In the next session, an investor buys 15 call option contracts, and there are no other trades that day, the volume is now 15 contracts.

Investors sometimes see volume as an indicator of the strength of a price move. The higher the volume, the more interest there is in the security. The higher volume also means that there is greater liquidity in the contract, which is desirable from a short-term trading perspective, as it means there is an abundance of buyers and sellers in the market.

Open Interest

Open interest is the number of options or futures contracts that are held by traders and investors in active positions. These positions have been opened (either buy or sell) not been closed out, expired, or exercised. Open interest, which is updated just once per day, decreases when buyers (or holders) and sellers (or writers) of options (or buyers and sellers of futures) close out more positions than were opened that day.

To close out positions, a trader must take offsetting positions or exercise their options. Open interest increases once again when investors and traders open more new long positions or writers/sellers take on new short positions in an amount greater than the number of contracts that were closed that day.

For example, assume the open interest of the ABC call option is 0. The next day an investor buys 10 options contracts as a new position. Open interest for this particular call option is now 10. The day after, five contracts were closed, 10 were opened, and open interest increases by five to 15.

Volume and open interest are sometimes used in technical analysis, as the numbers provide information about the buying or selling interest underlying a potential price move. However, one must also look further at whether the open interest is in calls or puts, and whether the contracts are being bought or sold.

Special Considerations

1. Rising prices in an uptrend while open interest is on the rise indicates that new money is coming into the market (reflecting new positions). This can be considered a sign of bullish sentiment if the increase in open interest is being fueled by buying or long positions.

2. Rising prices in an uptrend while open interest is on the decline could indicate that money is leaving the marketplace; this is a bearish sign.

3. Falling prices in a downtrend while open interest is on the rise might suggest that new money is coming into the market on the short side. This scenario is consistent with a downtrend continuation and is bearish.

4. Falling prices in a downtrend while open interest is on the decline possibly indicates that disgruntled holders are forced to liquidate positions and is a bearish sign. However, it can also indicate that a selling climax is near.

5. High open interest while prices drop sharply at a potential market top could be a bearish scenario if holders who bought near the top are now losing money, raising the potential for panic selling.

Option Open Interest

Open interest provides useful information that should be considered when evaluating an option position. When trading stock, there is a fixed number of shares to be traded, or shares outstanding. However, when trading an option contract, you may be opening a brand-new position or closing an existing one. That’s why whenever you enter an option order, it’s not good enough to simply say “buy” or “sell” as you do with a stock. You must also specify whether you are buying or selling “to open” or “to close” your position.

For each buyer of an options contract there must be a seller. From the time the buyer or seller opens the contract until the counter-party closes it, that contract is considered ‘open’. Open interest is the total number of option contracts that are currently open, contracts that have been traded but not yet liquidated by either an offsetting trade or an exercise or assignment. While there may be as many open option contracts as trader or market demand warrants, options do have position limits as established by exchanges and regulators to manage marketability and eventual contract closure following expiration dates.

Open interest is challenging to dissect. A common mistake among new traders to options is to consider open interest as the same as the number of option contracts traded. Both a “sell to open” and “buy to open” position can but will not necessarily increase open interest. Similarly, “sell to close” and “buy to close” can but will not necessarily decrease open interest. When an option is traded with one party opening and one party closing, the open interest remains unchanged. If both parties in the transaction are closing positions then the open interest decreases. If both parties are opening positions, then the open interest goes up. There is no way to exactly determine how many “sell” and “buy” positions or trades are executed, only the net total open interest amount. Like volatility, it has no directional component, it is just an end of day tally of unsettled contracts.

Open interest is calculated centrally on an end-of-day basis by the Options Clearing Corp (OCC) for US options. The next morning, Open interest is displayed on the OCC web site but it is not distributed industry-wide until the next business day morning. The impact of this difference is felt over the weekend when the OCC web site is showing Friday’s open interest but other financial sites are showing Thursday’s open interest. For the rest of the next trading day the open interest figures remains static. Open interest can vary from the call side to the put side, and from strike price to strike price.

Open interest is an especially important metric for market makers and professional traders. It provides insight in helping to choose which option strikes to trade, for example in executing dividend capture strategies. A large cluster of open interest around strikes can be interpreted as a possible trading opportunity and can signal a stock price pin at expiration. If a break in stock price occurs through a large open interest at a particular strike, the move can be magnified by forcing hedges and stop losses on option positions as the stock breaks through the strike prices.

High Open Interest can also be viewed as an indicator supporting current market moves or committed positions that are investment bets on future stock outcomes. Additionally, traders may further parse high open interest to specific expiration, strike and option type to assess what the order flow is actually targeting, and track the performance and implied volatility of that specific option.

By analyzing the changes in the open interest figures at the end of each trading day, some conclusions about the day’s activity can also be drawn. Increasing open interest is an indication that new investment is flowing into the market. The result will be that the present market momentum (up, down or sideways) is likely to continue. Declining open interest indicates the market is closing positions (liquidating) and implies that the current price trend may be coming to an end. Knowledge of open interest can also be useful toward the end of major market moves. A leveling of open interest following a sustained price advance is often an early warning sign of an end to an upward movement in the market. However, neither an increase in volatility nor open interest necessarily indicate anything about the direction of future price movements.

It is important to note that high open interest for a given option contract means there is high interest in that option, but it does not mean that those trading the contract have the same or a correct forecast on stock movement. For every option buyer who expects one result, there’s an option seller expecting something else to happen. Open Interest and Put/Call Ratios can be revealing indicators of how option traders and order flow are moving. Some investors consider put/call ratios as a contrary indicator because these metrics reach extremes at the height of an emotional trading event. Others may view this as a build up to a bigger and longer momentum play. The metrics can be used in combination with other statistics to gain an insight into order flow sentiment.

Market Chameleon provides several ways to view Open Interest information and trends:

    To view the Open Interest for a single contract use the Option Chain page.

Open interest and bullishness – Option Trading FAQ

Tracking stock volume and options volume are two entirely different monkeys, and particular attention needs to be paid to option volume and open interest. When a company releases stock on the market for the first time (initial public offering) it sets the number of shares it wants to release:

Ferrari SpA (NYSE: RACE) stock starts trading on Wednesday, Oct. 21. The Ferrari IPO plans to raise $860 million by selling 17.2 million shares at a $48 to $52 price range.

The take away when dealing with the Ferrari IPO (Initial Public Offering) is that they plan to release 17,200,000 shares. Unless Ferrari plans to make another secondary offering in the future, stock split or reverse stock split. This is the final amount of shares that will be available on the open market.

Options are created on various underlyings regularly and with no limit. This carries with it several advantages such as an infinite amount of choices to trade but also several disadvantages like low liquidity in most options. Not all options are going to be equal. We can use option volume and open interest to sort out the options we want to trade. We are going to look further into option volume, what it means and how we use it. We are also going to define open interest, and how it relates to options and how to trade around it and avoid the risk it carries with it.

What Is Option Volume

Options volume is straightforward because it is a lot like reading stock volume. Volume is always shown as a daily number. It is the number of contracts traded at that call or put on that specific strike and expiration.

If The Option Prophet (SYM: TOP) 35 strike puts were traded 3000 times today the volume for the 35 strike puts would read 3000. Tomorrow that volume number would reset back to 0 and increase as more contracts were traded.

It is easy to track stock volume because it is regularly measured and can often be viewed on a chart. There are so many options for a single underlying it is often more difficult to keep track. You would have to keep track of each call and put at each strike through multiple expiration dates (tedious). Some brokerages allow you to chart option strikes, but it’s typically not very helpful if you do.

The reason we care about option volume is that it deals with liquidity. Liquidity is defined by how easy it is to get in and out of a position at the price you want. When trying to trade in an illiquid market, it can often be difficult to get a good fill and often you will have to settle giving you a worse price than you wanted. A highly liquid market means it is quick to get fills at the price you want. In an illiquid market, you are often left with a massive bid/ask spread. The bid (the price you sell at) and ask (the price you buy at) are the prices you trade at. When these two prices are further apart, it puts you in a hole when you place the trade.

If TOP 35 strike puts have a bid of 0.25 and an ask of 0.50 that is a 0.25 spread. That means I begin in the hole $25 as soon as I buy or sell that option.

The more illiquid an option, the larger that spread will be. Typically higher volume stocks will have higher volume options. You can also find the more liquid options in near-term expirations versus expirations that are further out in time. At-the-money options will be more liquid when compared to out-of-the-money options or deep-in-the-money options.

What Is Open Interest

Open interest is a new concept when you first start trading options because it doesn’t exist in stock trading. Open interest tracks the number of open contacts on a specific strike for a call or a put. Like we mentioned previously, option contracts are created on an as-needed basis. Unlike stock, there is not a set amount of contracts floating out on the market. When a new expiration is created for an underlying, all the option contracts start with an open interest of zero.

When a trader buys to open or sells to open an option contract open interest will increase by one. When a trader sells to close or buys to close an option contract open interest will reduce by one. Open interest is not calculated in real-time. Changes occur in open interest after the market closes and can be seen the next day.

While it’s not definitive an option with low to zero open interest could signal low liquidity. Options that have expiration dates that are further out in time will have a lower open interest versus near-term options. Much like volume, which go hand-in-hand with open interest, at-the-money options will have higher open interest versus deep out-of-the-money or deep in-the-money options.

While open interest and volume do tell us what strikes the action is happening on it does not tell us if that action is bullish or bearish. A put strike could see its open interest increase by 100 in a day, but we do not know if that is because someone bought to open that put (bearish) or sold to open that put (bullish). We also don’t know if those options are paired with another play in that trader’s portfolio. If calls are sold to open (bearish) are they still bearish if they are covering stock?

The Definition Of Option Pinning

Option pinning is an interesting phenomenon where a stock’s price will move to end on a particular option strike. You will only see this happen with a strike has a considerable amount of open interest, at least 2x more than any other strike. This will also only occur on expiration day.

Let’s look at an example of why this happens. Imagine being a market maker with a considerable amount of contracts on a particular strike. For this example, you are long TOP 100 calls at the 35 strike while TOP is trading at $34.75. What you don’t want to happen is for TOP to move above $35 and you get placed 10,000 shares of TOP. As a market maker your not looking to take possession of stock. As TOP begins to move towards and above $35 you know you need to hedge your position. You start to short TOP while it’s above $35 and as this happens, it will begin to reduce the price. Once TOP falls below $35, you can start to buy back your short position thus raising the price.

This can also affect your average trader. If you are also long calls at the 35 strike, you may not want to take possession of the stock. At the same time, you may not have the same portfolio size or ability to hedge your position by buying and selling the underlying. It is usually best to not hold options so close to expiration. You especially want to be aware when there are candidates for pinning.

What Makes A Good Pin Candidate?

  • High volume underlying stock
  • High volume options
  • Expiration day
  • Strike with double the open interest versus all other strikes at that expiration
  • The large spread between each strike – $5 wide strikes versus $1 wide
  • Monthly expiration dates versus weekly options

How You Can Profit From Option Pinning

When an option pins it restricts its movement and settles down to an observable dollar amount. To take advantage of this lack of movement and predictability you need to be a net seller of options. Two of the best strategies are short strangles and short straddles. Iron condors can also be used for a lack of movement but you are not going to get any good prices or fills on expiration day and commissions are going to eat away at what you do get. The same could be said about short strangles. The amount of range you get won’t be substantial since the premium won’t be in the options. Short straddles should be used for maximum profitability. Find the strike you think is going to pin and initiate a short straddle on that strike. If all goes according to plan your two options should expire worthless allowing you to collect your full premium.

Conclusion

There are hundreds of different options out there. Not every option should be traded because it exists. Low liquidity due to a lack of volume and interest will make it difficult to enter and exit a position promptly while receiving a fair price. Options that are closer to the expiration day and closer to being at-the-money will have higher liquidity.

Higher liquidity can bring unwanted circumstances in the form of option pinning. There are two reasons to watch out for option pinning. If you are in a position, you need to know if there is potential for a pin. This could affect your position by putting you in or out of the stock when that was not your intention. If you are careful, you can also profit from a pin by employing short straddles or strangles. Not every pin candidate will pin but when they do it is an interesting phenomenon.

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