What are options - and why add them to your portfolio? In this back-to-basics series, TradeKing’s Brian Overby explains options from the beginning, from opportunities to risks. This post discusses “open interest” on options and why it matters to you. Welcome back-to-school, traders! So far in this blog series we’ve defined options, both calls and puts, explained what sports and movie contracts have in common with investment options, and showed how an option contract’s terms are spelled out in its name. We’ve also examined the basic parts of an options chain, including glossing key concepts like delta, open interest and implied volatility.
Today we’ll unpack one of these concepts, “open interest”, in more detail.
First off, what IS “open interest”? Well, unlike shares of stock, there isn’t a fixed number of any options contract out there in the marketplace. Rather option contracts get issued or retired based solely on trader demand. So “open interest” simply tells you how many open contracts already exist for a given strike.
Let’s look again at the IBM option chain I showed you before. You can access this and options on any other stock at Quotes + Research > Options Chains. (Make sure you login first.)
See a larger version of this image.
Take a closer look at the November 09 puts on the right. Again, the gray stripe down the middle gives you the strike prices for each option contract. The 120 strike would be more or less at-the-money (ATM) in this example, if IBM is trading at 123.06. (When the strike price equals the current stock price, those options are called “at-the-money”. Options can also be “in-the-money” or “out-of-the-money”.) 120 puts have open interest of 7,031 contracts.
The next strike, 125, is also more or less ATM; its open interest is 4,456. What open interest means here is pretty simple: as of this moment in time, option traders have opened 4,456 contracts trading Nov09 125 puts and 7,031 contracts trading Nov09 120 puts. Like any contract, each option contract involves a buyer and a seller. The buyer gets rights that he or she can exercise at will; the seller incurs obligations in exchange for earning money, or a “premium”, for the option sale.
Skip down to the 135 strike on the puts side. It might seem juicy to buy a put option that gives you the right to sell IBM at 135. After all, everyone else is selling IBM for just 123.06! But check out the open interest on the 135 put: it’s just 334 contracts. You might be very happy to buy this put, but not too many folks are currently interested in taking the other side of that contract. That’s why there aren’t that many contracts afloat right now.
There are two key takeaways on open interest here:
You can’t just “buy” or “sell” an option. You have to specify if you’re buying or selling “to open” a new option contract or “to close” an existing one. Opening new contracts adds to that option’s open interest. Closing contracts means open interest goes down.
Open interest is an important measure of an option’s liquidity. “Liquidity” refers to how many shares or units of a security are available to trade at any given time. A highly liquid stock like IBM has millions of stock shares available on the market; its liquidity means that it’s relatively easy to sell IBM stock if you want to.
Liquid stocks also tend to have very tight prices between bid and ask. That is, there’s less of a price discrepancy between what someone is willing to sell stock for, versus what someone will pay to buy it.
For illiquid stocks and options, though, it can be tougher to get out of a position. There may simply not be enough buyers and sellers to take the other side of your trade. Or you may find someone to transact with, but you may have to settle for a price you’re not happy with.
High open interest means you’re dealing with a liquid options contract; low open interest means the opposite. Put more simply, a contract with high open interest is one that a lot of options buyers are interested in buying or selling. Low open interest, as the name implies, means less trader interest.
It’s important to note that open interest doesn’t say anything about bullish or bearish sentiment in an option. After all, each open contract involves a buyer and a seller with opposite views on where the underlying is headed.
Who keeps track of open interest? The Options Clearing Corporation (OCC). The OCC keeps tabs on all the opening and closing transactions for options and tallies open interest from that. They track open interest at several levels: the individual-contract level, what we’ve been discussing here, is the most granular level. You can also check out open interest for ALL options on a given stock, or for all puts or all calls on that stock, and so forth.
Next time, we’ll talk about implied volatility (IV), another data-point on the options chain that’s very useful to options traders. Tune in again for that!
Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com
[image: Lomo Spring Creek School House by kevindooley on Flickr]
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.
Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.
Supporting documentation for any claims made in this post will be supplied upon request. Send a private message to All-Stars using the link below the profile image.
While Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security there is no guarantee that this forecast will be correct.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice.
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