Often I get the question about why I would choose an option with low open interest. Hopefully I can shed light on why open interest is important and to better define it for those who don't fully understand what it is.

Let's start with a definition. Open interest tells 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, exercise or assignment. In easier terms, if I buy-to-open an Oct 50 call, I increase open interest by 1. If I sell-to-open the same option, the open interest climbs by 1. If I decide to sell-to-close, or buy-to-close, this will reduce the open interest by the amount of contracts traded. Another scenario would be if I want to buy-to-open 1 contract, and I get paired with another order that wants to sell-to-close this same contract, open interest will remain unchanged.

Many get volume and open interest confused. We have discussed what open interest reflects, now let's define volume. Volume is the total number of contracts traded. An example might be...100 contracts traded hands today, but the open interest is unchanged. This means the opening transactions were matched with closing transactions and no open contracts were left on the table. What would this tell you? Bulls and Bears were in balance today.

Now that we've stated the definitions, let's talk about the application. Many get hung up on the "1oo contracts minimum of open interest!!!" Why? If you are ever given a "rule-of-thumb" in trading, always ask "why is this important?" I will tell you a few reasons why it is important, and a few reasons why it is not important.

Realize that if you are trading options with more open interest, this means more people are interested in this trade. This is a good thing. The more people that are interested, the better the pricing will be. What if I come across an option with little or no open interest...does this mean I don't buy? You can surely pass on the option, but why would you? If other traders are not trading this option, what does this mean? Perhaps you have picked an undesirable option...or the option has just recently been issued. Do you care what other traders are doing anyway? Aren't the majority of option traders wrong anyway?

Don't tell me it is a liquidity issue. You do not have to find the other party in the trade...this is where the market maker comes in. If he has a price listed, doesn't he have to honor that price? Whether there is another trader or not, he sets the price, and if the price is right...we buy. To me it is not a liquidity issue since I have traded options with little or no open interest on many occasions. In my eyes, the only issue lies in a statement I just made. I said "If he has a price listed, doesn't he have to honor that price?" Low open interest effects the price of the option. If you have no demand, can't you manipulate the price a little? Normally in low open interest scenarios, there will be a very wide spread between bid and ask. This is something I pay close attention to when trading a low open interest option. If the spread is huge...30, 40, 50 cents or higher, I'm likely to pick another option. However if the price looks good, the spread is decent, I will be the first to grace the open interest column any day.

Hopefully this will clear up any questions on this topic. I am not suggesting to jump into low open interest options...I am saying that if the reward in the trade is good enough to warrant any risk, and the price of the option looks good, trade away.

Posted by Option Addict on 9/07/2006 at 3:08 PM | Permalink