Stock Option Trading 104: Open Interest And Spreads

| February 25, 2015 | 0 Comments

Back To BasicsMore Stock Option Basics…

Here’s another dose of stock option basics for anyone interested in discovering the powerful profit potential of options trading.  As you know, option trading is the prime focus of my premium trading service, the Options Profit Pipeline.

In my last options basics article, we discussed the difference between intrinsic and time value.  It’s an important topic, so make sure you read that article.

Let’s continue today with another very important discussion on open interest.  You’ll learn what it is and how it helps determine option bid/ask spreads- a key factor in the price you pay for a particular contract.

And before I forget…

Stick around to the end of today’s article and you’ll find a hot options trading tip!

Here we go!

Open Interest: How Much Activity Is There?

Before we get into open interest, let me tell you something you may not realize.

Unlike stocks, which have a fixed number of shares available for trading, there is no limit for the number of option contracts available to traders.

Instead, trader demand is what dictates the number of stock option contracts.

What does that have to do with open interest?

Well, open interest is simply the number of open option contracts that exist for a particular stock on any given day.

Open interest fluctuates from day to day as traders open and close option positions.

It’s important to note that open interest is tallied for all option contracts on a stock and more specifically for various strikes (put and call) in the option chain.

Let me give you an example…

For the sake of explanation, let’s say the open interest on the EOG Resources (EOG) April 2015 $95 calls is zero (0).  But one day a trader “buys to open” 1,000 call contracts in the $95 strike, creating a bullish position.

Due to the new position, open interest for the $95 calls will increase from 0 to 1,000 to reflect the number of new open positions.  Any additional “buy to open” orders in this call strike will increase the open interest proportionately.

Now stick with me…

Say the price of EOG rises over the course of a few days and our trader wants to collect a partial profit off those $95 calls.  As a result, he/she “sells to close” 400 contracts.  When this happens, 400 contracts are subtracted from the open interest, making it 600.

Now keep in mind, open interest reflects all “open” option positions in a strike.  As a result, short positions (when a trader “sells to open” a call or put) are reflected in open interest as well.

But don’t let that confuse you.

The important thing to realize about open interest is that it defines the amount of trading activity, or trader “interest” in a particular strike. 

Now listen closely…

Open interest is calculated once a day by the Options Clearing Corporation (OCC).  As a result, the open interest reading you see on any particular call or put option is from the previous day.

Let me explain why that little tidbit of information is important…

Stock Options: Two Reasons To Watch Open Interest!

The first reason is simple.

The higher the open interest in a particular stock (and strike), the more likely it is you’ll be able to perform a fair transaction in the option.  You see, stocks with high open interest typically have much tighter bid/ask spreads in their option chains.

On the other hand, if open interest is low, bid/ask spreads are wider.  A wide spread makes it much tougher to open/close your option trades at a fair price.

What’s the lesson here?

If you want to trade options, stick to stocks with good open interest.

The second reason to watch open interest is much more interesting…

Whenever the daily number of option contracts traded (the volume) on a particular strike is much higher than the open interest, it can give you insight into the future direction of a stock.

Remember, the open interest reading you see on any particular day is from the previous day.  So if daily volume is far exceeding the open interest, it can mean someone is making a big bet on the company that day.

For example…

Let’s imagine the open interest on the previously mentioned EOG Resources (EOG) April 2015 $95 calls is 1,000.

But during the trading day, you notice someone buys 10,000 contracts of the $95 calls.

The big jump in daily volume (10,000) over the open interest (1,000) is a good sign someone with substantial resources is opening a new bullish position in EOG. 

To take it a step further, at the time of the trade, those $95 calls were priced at $2.20.  That means someone just made a $2.2 million (10,000 x $220) bullish bet in the name!

Sound outlandish?

Big options bets like these happen with stunning regularity!

Of course, there are hundreds of option contracts trading each day in thousands of stocks.  How do you catch this kind of unusual option activity?

Stay tuned to Commodity Trading Research, because that’s a topic for another day… 

Until Next Time,

Justin Bennett

BIO:  Justin Bennett is the head commodity research analyst at Commoditytradingresearch.com.  With over a decade of real world trading experience, he finds ways for you to consistently profit from movements in commodities and the companies producing them.  Sign up for our free reports and commodity newsletter at http://commoditytradingresearch.com/free-sign-up.

Tags: , , , ,

Category: Commodity Options Trading

About the Author ()

Justin Bennett is the editor of Commodity ETF Alert, an investment advisory focused on profiting from the ebb and flow of important commodities via ETFs. The commodity veteran and options specialist is also a regular contributor to the Dynamic Wealth Report. Every week, Justin shares his thoughts with our readers on a variety of commodity-related topics. Justin is also a frequent contributor to Commodity Trading Research’s free daily e-letter. And he’s the editor of another highly successful and popular investment advisory, the Options Profit Pipeline.

Leave a Reply