Why Volume and Open Interest Matter to Liquidity
In a few recent posts I discussed Options Bid/Ask Spreads and Liquidity as well as Expirations and Strike Prices. I mentioned that volume and open interest factor into liquidity when it comes to bid/ask spreads but I wanted to expand more about how and why these two indicators matter in the grand scheme of things when evaluating the important topic of option market liquidity. Remember as a trader you want to focus on the stocks that have the best liquidity because it will make it easier to move in and out of trades at a price that is fair. Sometimes bid-ask spreads can widen out with market volatility and news but as long as there is plenty of volume and open interest in a product that helps traders know that bid-ask spreads will stay narrow and tight before expiration.
Volume simply shows the number of options or shares of stock an underlying product is trading that day. Stock volume just adds up all the shares traded on each given day. But with options having so many different expiration cycles going out over 2 years even and many various strike prices depending on the stock it’s much more scattered where the volume generally trades most. Overall on most liquid stocks, the majority of options volume is traded in the front month options expiring within 30 days. The higher the volume then the more interest from traders that stock or option strike is seeing in the market. Another good point to know is that volume tallies up all transactions, opening and closing trades.
So if I bought 100 shares of AAPL and sold those 100 shares on the same day that would add 200 shares to the volume total for that day. Same way in the options market, if I sold a bull put spread (2 separate options strikes) on TSLA today and then bought it back on the same day for a profit then the total volume on each of those strike prices would go up by 2 contracts.
The more volume a stock is trading each day, the more action it has and that likely produces deeper liquidity as a result since there are more buyers and sellers coming together and “making a market”. In general higher volume in a stock translates to tighter bid-ask spreads in the stock and options underlying which likely leads to more volume traded in the options. One reason behind this is because market makers or dealers need to hedge the options they buy/sell to customers and the only way to hedge an option’s risk is to trade stock against it. Much of the volume we see in the market each day is very tied to hedging activity from so many large funds and institutions that cannot quickly move in and out of the markets as retail traders. The bottom line is that the more volume a stock trades the better off you will be when trading its underlying options because more volume leads to narrower bid-ask spreads.
Another important fact these days is the increase in volume with weekly options and the stocks with the highest volume traded generally have weekly options expirations. It has become a good filter for stock liquidity. If a stock does not have weekly options it tells me there is not as much interest or activity from the market and I might be better off avoiding the options in that stock since they will be more thinly traded. With options markets it’s best to avoid the quiet stocks because they are quiet for a reason. When stocks get busy and volatile that’s usually going to offer opportunity in some way or another.
Open interest only applies to options or futures contracts or anything with an expiration date. Basically as it sounds, open interest shows the current amount of open contracts at each strike price. Higher open interest indicates a high level of participation from the market. This generally adds to liquidity and makes the bid-ask spreads of options tighter. Just like a popular sporting event that is sold out, when the interest is high in a strike price, that’s an indicator a trader wants to be involved and trading a particular stock that has many other participants trading and creating open interest.
To further touch on a sports analogy with volume and open interest, you can say volume is the amount of tickets sold to a football game in total. But open interest is who actually showed up with their ticket and stayed for the whole game. We might have plenty of ticket holders that paid for entry to the game but if the weather changed or a player got injured and expectations changed beyond the short term then maybe not as many fans showed up to the game or left the stadium at halftime. Trading is similar in that a lot of players are trading short term moves and that adds to the volume of a strike price in the options market which may show up as a large total traded volume number. But if market expectations change and they don’t stay in the trade for more than that day then it will not be added to open interest.
If I bought to open a call on SPY and the seller who sold it to me also was opening the transaction to sell on their side then the trade is counted as an open contract that adds to overall open interest for the strike price traded. Instead if I was selling an existing open long call position then this closing of the trade would decrease open interest by one contract. A lot of traders like to track open interest and how it changes to show if there is true demand and interest for a stock that is moving in one direction. Many of these large gamma induced moves we sometimes see are generated by open interest expanding to higher strikes and at a faster velocity than market makers anticipate. This forces stock buying from dealers to hedge risk and can fuel moves farther than most traders expect. The options market is so large and growing monthly at a rapid pace so open interest changes have shown to be a force like never before.
What is Considered High Volume & Open Interest?
Overall if we know that more volume and open interest helps produce liquid markets then how much is enough? For stocks it depends on your timeframe but a general rule of thumb is most stocks that trade over 1 million shares in average daily volume likely have enough options volume liquidity to trade short term moves. There might be exceptions to this and likely there are stocks that trade 500k volume per day that have sufficient liquidity in their options for putting on a swing trade but the more the better. When I’m trading I like to trade options that have at least 100 contracts traded and open interest of over 1000 is always a good starting point. The more activity in an option strike then the easier it will be to enter and exit without slippage or too much give up in theoretical value between the bid-ask spread. If you are just day trading then the current day’s volume in that option strike is a better indicator of liquidity based on your timeframe. But if you are entering a trade with a 1-2 month time horizon in mind then focusing on open interest is a better way to evaluate future liquidity for when you will want to exit your trade.
- Stock volume represents the total number of shares traded that day.
- Options volume shows the total number of option contracts traded at each strike price and expiration on that day.
- Open interest is the number of options contracts currently open and being held by traders at each strike and expiration date.
- Open interest is a better way to evaluate future liquidity while volume is a good indicator of today’s activity.
- Stocks with weekly options have higher overall liquidity and activity than stocks with just monthly expirations.
- The higher volume and open interest are then the higher the liquidity of that stock and its corresponding bid-ask spreads.