In options trading, several crucial indicators can guide you to a smart speculation. These include open interest and volume. Although both measure the current market activity in the option, they reveal two different aspects of that activity. Options buyers consider them together when making a decision to buy or sell.
Options are contracts to buy or sell shares of underlying stock, or stock indexes, at a specific price and until a specific expiration date. An option is a contract which binds the buyer and seller to certain actions. Open interest shows the number of options contracts that all investors currently hold. Complete options tables show open interest for each option contract, as well as its strike price and expiration date. Futures exchanges, such as the Chicago Board Options Exchange or CBOE, establish the options and control the market.
The option volume parallels the stock volume indicator, showing how many contracts have been bought and sold over a single trading session. Volume provides an excellent clue to the current interest in the option by traders; the higher the volume, the more liquid the option and the narrower the spread between the "bid" and "ask" prices.
Open Interest v. Volume
Both indicators show the relative activity in an option (or futures) contract. The open interest shows the entire market for the option - how many contracts are held by all traders. The number increases when a trader opens a position, and decreases whenever a position is closed by an offsetting trade or an exercise of the option. It varies less than volume, which swings through a much greater range as interest in the option and the stock fluctuates from day to day. Generally, both numbers are much higher for options that are at the money, meaning their strike price closely matches the price of the underlying stock.
In general, the further from the strike price, the lower the option's volume. With low volume, it is more difficult to profitably trade options, as it is more difficult to place an order at the price you want. Experienced options traders appreciate both high volume and volatility - the larger the fluctuations in price, the better their chances of making a profit if they buy or sell the option at the right time (and in the right direction).
By comparing volume and open interest, you can gauge the market's interest in the option. When the volume approaches or exceeds the open interest, then you know that the market has become quite active. Strong price moves on a high-volume day are a good indicator of significant moves in the option.