Price movements in the options market result from the decisions of millions of traders. But there are a number of useful statistics besides price movements that tell you what those other market participants are doing.
Here we take a closer look at two factors you should consider when trading options: Trading volume gives you important insight into the strength of the current market direction for the option's underlying stock.
The volume, or market breadth , is measured in shares and tells you how meaningful the price movement in the market is. Keep in mind that trading volume is relative and needs to be compared to the average daily volume of the stock in question.
A large percentage change in price accompanied by larger than normal volume is a solid indication of market strength in the direction of the change. But large percentage increases in price accompanied by small trading volumes are less likely to indicate a market direction. In fact, they may indicate that a reversal is likely in the near term. The Importance of Open Interest Open interest is a concept all option traders need to understand. Although it is always one of the data fields on most option quote displays - along with bid price , ask price , volume and implied volatility - many traders ignore open interest.
But while it may be less important than the option's price, or even current volume, open interest provides useful information that should be considered when entering an option position. First, let's look at exactly what open interest represents. Unlike stock trading, in which there is a fixed number of shares to be traded, option trading can involve the creation of a new option contract when a trade is placed.
Open interest will tell you the total number of option contracts that are currently open - in other words, contracts that have been traded but not yet liquidated by either an offsetting trade or an exercise or assignment.
For example, say we look at Microsoft and open interest tells us that there have been 81, options opened for the March You may be wondering if that number refers to options bought or sold. The answer is that you have no way to know for sure. When you buy or sell an option, the transaction needs to be entered as either an opening or a closing transaction. If you buy 10 of the Microsoft March That purchase will add 10 to the open interest figure. If you wanted to get out of the position, you would sell those same options to "close" and open interest would then fall by Selling an option can also add to the open interest.
If you owned 1, shares of Microsoft and wanted to do a covered call by selling 10 of the March Since it is an opening transaction , it would add 10 to the open interest.
If you later wanted to repurchase the options, you would enter a transaction to buy to close. Open interest would then decrease by Things get a little more complicated if the options you trade are not created by the transaction, but instead the other side is taken by someone doing a closing transaction. For example, if you are buying 10 of the Microsoft March So when you are looking at the total open interest of an option, there is no way of knowing whether the options were bought or sold - which is probably why many option traders ignore open interest altogether.
However, you shouldn't assume that the open interest figure provides no important information. One way to use open interest is to look at it relative to the volume of contracts traded. When the volume exceeds the existing open interest on a given day, this suggests that trading in that option was exceptionally high that day.
Open interest can help you determine whether there is unusually high or low volume for any particular option. Open interest also gives you key information regarding the liquidity of an option. If there is no open interest for an option, there is no secondary market for that option. When options have large open interest, it means they have a large number of buyers and sellers, and an active secondary market will increase the odds of getting option orders filled at good prices.
So, all other things being equal, the bigger the open interest, the easier it will be to trade that option at a reasonable spread between the bid and ask. Trading does not occur in a vacuum.
Indicators and reports that show you what other market participants are doing can be a valuable addition to your trading system. Daily trading volume and open interest can be used to find trading ideas you might otherwise overlook. These indicators are also useful for making sure that the options you trade are liquid, allowing you easily to enter and exit a trade, as well as ensure you get the best possible price. Dictionary Term Of The Day.
A conflict of interest inherent in any relationship where one party is expected to Broker Reviews Find the best broker for your trading or investing needs See Reviews. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. A celebration of the most influential advisors and their contributions to critical conversations on finance.
Become a day trader. Daily Trading Volume Trading volume gives you important insight into the strength of the current market direction for the option's underlying stock. The Bottom Line Trading does not occur in a vacuum. A conflict of interest inherent in any relationship where one party is expected to act in another's best interests. Passive investing is an investment strategy that limits buying and selling actions.
Passive investors will purchase investments How much a fixed asset is worth at the end of its lease, or at the end of its useful life. If you lease a car for three years, A target hash is a number that a hashed block header must be less than or equal to in order for a new block to be awarded. No thanks, I prefer not making money. Get Free Newsletters Newsletters.More...