Jan 02, 2024 By Susan Kelly
Options and futures contracts' liquidity and activity may be described by two major technical metrics: volume and open interest. The term "volume" describes the total number of contracts exchanged over a certain time frame, whereas "open interest" describes the number of contracts that have not yet been closed. Here, we take a closer look at these two indicators and provide some pointers on how to utilize them to interpret derivatives market behavior.
A stock market's volume indicates the frequency with which shares are traded. The volume statistic is used in the options market to determine the degree of activity for a specific contract and to keep track of the total number of purchased and sold options contracts during a given trading day.
The daily volume is the sum of all trades, whether they be opening or closing trades. Higher volume indicates that more people are buying or selling the underlying security. To some extent, volume is used by investors as a proxy for the magnitude of a price change.
Liquidity, or the number of buyers and sellers in the market, increases in tandem with trade volume, which is positive from a short-term trading standpoint.
"open interest" refers to the total number of open options and futures contracts owned by market participants. These positions have been initiated but have yet to be closed, expired, or exercised. Open interest falls when more contracts are closed out by buyers and sellers than were opened that day.
A trader must either take an opposite position or execute an option to close a position. Open interest rises when more contracts are opened than closed, either because buyers take on more long positions or sellers take on more short ones.
Consider that the ABC call option has no open interest. The next day, the investor initiates a new position by purchasing ten options contracts. Right now, there are ten people interested in buying this call option. Five contracts were closed, and ten were opened the next day, raising the open interest by five to fifteen.
We then attribute various meanings to these instances using the volume and open interest metrics.
However, a drop in open interest alongside dropping prices in a downtrend is a negative indication since it may signal that holders are being compelled to liquidate their positions. Also, if this happens, a sales peak may be on the horizon.
Security options are listed in an option chain or options matrix table. All of the listed calls and puts for a certain maturity date are shown in one place in an option chain, together with relevant information such as strike price, expiry date, volume, and price.
Both strong volume and open interest are signs of a healthy options market with many willing buyers and sellers. Likewise, shifts in open interest and volume can attest to the authenticity of market sentiment. For instance, a strong option market is characterized by a rising price, growing volume, and open interest. In contrast, a weak market is characterized by a rising price, declining volume, and open interest.
If an option has a large volume but low open interest, it may have a small secondary market and poor liquidity. A wider bid-ask spread or trouble finding a buyer might discourage a trader from trying to offload the option.
When there is a lot of "open interest" in a futures or options contract, many people actively trade that particular contract. Over time, an increase in open interest indicates that more investors are buying into the market. A gradual drop in open interest indicates that investors are unloading their holdings.
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