Why Trading Volume and Open Interest Matter to Options Traders

In this article, we will discuss

• What is Trading Volume in Options Trading?
• Why is Trading Volume in Options Trading Important?
• What is Open Interest in Options Trading?
• Why is Open Interest in Options Trading Important?
• Using Trading Volume and Open Interest: An Example
• Conclusion

To be consistently successful at options trading, simply understanding the basic mechanics of options contracts may not be enough. As a matter of fact, you must delve deeper into the various intricacies of the trading segment. Two of the most important metrics that experienced traders rely on are trading volume and open interest in options trading. These indicators provide valuable insights into market sentiment, liquidity, and potential price movements, enabling traders to make more informed decisions.

Speaking of informed decisions, Samco Securities’ Options B.R.O. is a comprehensive options builder tool that helps you build, test, and deploy various strategies based on your risk tolerance level. With Options B.R.O. and real-time market data on trading volume and open interest on the Samco Trading App, you can elevate your options trading game and achieve consistent success.

Now, getting back to trading volume and open interest in options trading, let us explore these two concepts and try to understand their significance and how you can use them when buying and selling options contracts.

What is Trading Volume in Options Trading?

Trading volume in options trading is a metric that refers to the total number of options contracts bought and sold during a specific period, usually a single trading day. Every time a contract is bought or sold, the trading volume changes. Here is an example to help you understand how this works.

Assume there is a stock XYZ Limited that is currently trading at Rs. 2,100. If 100 call option contracts of XYZ Limited with a strike price of Rs. 2,200 are traded in a day, the trading volume for this particular call option contract would be 100.

Since the trading volume is measured for each call and put option contract of an asset separately, it can vary significantly between different strike prices and expiration dates. Usually, contracts with strike prices that are closer to the spot price (in-the-money or at-the-money contracts) tend to exhibit more volumes on the trading volume chart compared to contracts with strike prices that are far from the spot price (out-of-the-money contracts). The same is the case with the contract expiration dates. Contracts with near-month expiries have more trading volume than contracts with next-month or far-month expiries.

Why is Trading Volume in Options Trading Important?

The trading volume charts are often considered to be very important by options traders for many reasons. Here is a brief overview of a few of them.

• Liquidity Assessment

Examining the volume when trading can help you easily determine the liquidity on the counter. High trading volume generally indicates good liquidity, which means that you can enter and exit positions more easily without making significant compromises to the price.

• Market Interest

Tracking the trading volume chart can also give crucial insights into market interest. An options contract with steadily increasing trading volume often indicates a growing interest, which may even lead to potential price movements in the direction of the contract.

• Trend Confirmation

By comparing the trading volume with price action, you can confirm the strength and validity of a trend. For example, rising volumes combined with increasing prices could be used to confirm a strong uptrend.

• Volatility Indicator

Trading volume can also be used to determine market volatility. For instance, a sudden spike in the trading volume in options contracts could indicate increased volatility. Increased volatility can affect option prices and trading strategies.

• Options Strategy Selection

Analysing the trading volumes at various strike prices can help you choose the most appropriate options and strategies. For example, if a particular options contract is experiencing high trading volumes, you can consider using a volume trading strategy to capture price movements.

• Price Discovery

Higher trading volumes in options contracts can lead to more efficient price discovery since more traders are participating in the market by avoiding options mispricing.

What is Open Interest in Options Trading?

Open interest in options trading is a metric that represents the total number of outstanding option contracts that have not been settled. Unlike trading volume, which measures daily activity, open interest provides a cumulative count of active contracts. Here is an example to help you understand how this works.

When a new options contract is created (opened), the open interest increases by one. On the other hand, the open interest decreases by one when an existing contract is closed, exercised, or expires. That said, if a contract is traded between two parties who already hold positions, open interest remains unchanged.

As with trading volume, the open interest is measured for both call and put options separately. The open interest will vary significantly depending on the strike price and contract expiration date, with in-the-money and at-the-money contracts having higher interest than out-of-the-money contracts.

Why is Open Interest in Options Trading Important?

Open interest in options trading is also a very crucial metric for traders. Here are a few key reasons why it matters the most.

• Market Depth

High open interest usually indicates a more mature and potentially more liquid options market for a particular strike and expiration.

• Contract Popularity

By analysing the open interest, you can easily identify which strike prices and expiration dates are the most popular. In addition to this, you can also reveal market expectations. For instance, if a call options contract with a strike price of Rs. 22,000 has the highest open interest, it could mean that the price of the asset would move towards Rs. 22,000 on the expiration date.

• Trend Strength

Open interest analysis can also reveal the strength of a particular trend. For example, increasing open interest along with an increasing or decreasing price trend could suggest a strong trend, whereas reducing open interest with a price trend often indicates a weakening trend.

• Options Expiration Insights

As the contract expiration date approaches, changes in open interest can signal whether positions are being closed or rolled over to future dates. These insights can be highly useful for determining the type of options trading strategy to use.

• Potential for Volatility

If the open interest at a certain specific strike price is high, it could lead to increased volatility as the contract expiration date approaches. This is especially true if the underlying asset’s price is also near the strike price.

• Put/Call Ratio Analysis

Open interest in options trading is crucial for put-call ratio analysis. Put-call ratio analysis is a technique used to gauge market sentiment. A higher put-call ratio suggests bearish sentiment as more puts are being bought, whereas a lower ratio indicates bullish sentiment with more calls being purchased. This metric can help predict potential market reversals.

Using Trading Volume and Open Interest: An Example

Now that you are aware of the concepts of options volume in trading and open interest, let us take up a hypothetical example to illustrate how you can use both of these metrics to make effective trading decisions.

Assume there is a stock XYZ Limited, which is one of the many high-volume stocks in the market. It is currently trading at Rs. 520 on the spot market. You expect the price of the stock to rise in the future. Therefore, to profit from the expected price movement, you decide to purchase call options with a near-month expiry. On analysing the trading volume chart and open interest, you get the following data:

From this data, you can get the following insights:

• Liquidity

The call option contract with the strike price of Rs. 550 has the highest trading volume and open interest. This indicates that this particular contract is the most liquid and easiest to trade with the tightest bid-ask spread.

• Market Sentiment

The high open interest and volume at the Rs. 550 strike price suggests that options traders are positioning for potential upside in the stock of XYZ Limited.

• Activity

The trading volume at the Rs. 550 strike price is relatively high compared to its open interest. This could suggest increasing bullish sentiment and indicate new positions being opened.

• Potential Support Level

The call options contract with a strike price of Rs. 500 has the second-largest open interest. It could potentially act as a strong support level for the stock price as expiration approaches.

Based on the above analysis, you can consider purchasing a call options contract with a strike price of Rs. 550 since you are bullish and the contract is most liquid. Additionally, you could set a stop-loss point at Rs. 500 since there is significant trading volume and open interest, which would likely act as a support level for the stock price.

Note: This is a simplified example designed to help you understand how you can use the insights from trading volume and open interest to make effective trading decisions. In real trading scenarios, you would have to consider a host of other factors like implied volatility, underlying asset technicals, and broader market conditions.

Conclusion

Trading volume and open interest in options trading are powerful metrics. Although they do not predict future price movements, they provide valuable context about market liquidity, sentiment, and potential areas of support and resistance. By incorporating these metrics into your analysis and decision-making process, you can make more informed decisions about which options to trade, when to enter or exit positions, and how to manage risk.

To leverage these insights effectively, you need a robust trading platform such as the one offered by Samco Securities. The Samco Trading App provides real-time data on trading volume and open interest for all available option contracts. Additionally, you also get to use the power of Options B.R.O., a comprehensive options strategy builder capable of deploying a wide range of single-leg and multi-leg strategies.

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