Stock Option Chains: Open Interest and Volume

admin — Sun, 13 Dec 2009 10:36:37 +0000

As covered call writers, we have all looked at option chains. That’s where we determine how much cash will be generated into our accounts when we sell our options. It’s fun! We first inspect the current price of the underlying security (stock or ETF). Then we check out the closest strike prices (I-T-M, A-T-M and O-T-M) and take note of the bid and ask prices. For I-T-M strikes, we will also look at the amount of intrinsic value that the option premium consists of. If we are interested in a particular option, we will make note of the option symbol, usually found to the left. Let’s look at a typical options chain for a stock (MELI) that is in my portfolio at the time this article was written (November, 2009).

Current market price: $48.59

Options Chain for MELI 11-29-09

I have highlighted two columns that tend to be overlooked, Vol (ume) and Open Interest. Although many investors assume these stats are similar, they are, in fact, quite different. The purpose of this article is to discuss that distinction and the significance of each figure.

Vol(ume):

This is a measure of the number of transactions that transpired for a particular options contract for that day. It signifies how many times a day a particular contract has been bought or sold. The higher the volume, the greater the liquidity. A contract with zero volume should NOT be considered illiquid because it takes time to build up volume during the day. Also, an exchange specialist or market maker will step in to take the other side of the transaction. On the above options chain, the volume for the O-T-M $50 call is 202 contracts bought or sold thus far that day.

Open Interest:

This is the number of options contracts that are open or outstanding on a particular day. Options with large open interest have a secondary market of buyers and sellers. This will allow that option to be traded at a reasonable bid-ask spread. The open interest for the $50 strike on the above chart is 2282 contracts.

The Mathematics of open Interest:

There are four types of options trades that can be executed. Two will increase open interest and two will decrease it:

Buy to Open (BTO)- Increases open interest by creating a new long position
Sell to Open (STO)- Increases open interest by creating a new short position
Buy to Close (BTC)- Decreases open interest by closing an exisiting short position
Sell to Close (STC)- Decreases open interest by closing an exisiting long position

Trading Activity and Open Interest:

_________________________________________________________________________

TRADING ACTIVITY	CURRENT OPEN INTEREST		VOLUME

Trader A: B-T-O 6 contracts		6	6

Trader B: B-T-C 2 contracts		4	8

Trader C: S-T-O 8 contracts		12	16

Trader D: S-T-C 3 contracts		9	19

__________________________________________________________________________________

As you can see, open interest is not the same as volume. With volume, both entries and exits cause volume to increase but in the case of open interest, entries will cause an increase and exits a decrease in open interest.

Significance of Open Interest:

Increasing open interest shows strength in the current price movement of an option in much the same way as a volume spike will enhance the significance of a change in a technical indicator like the MACD. Decreasing open interest shows a weakening of the current price movement. If the price is increasing on increasing open interest, the likelihood of continued price increases is greater. If open interest starts decreasing, that upward price movement is starting to weaken. Also, as mentioned earlier in this article, the greater the open interest, the more favorable the bid-ask spread is likely to be. Open interest of 20 contracts or less (2000 shares) is thought to have relatively thin liquidity.

Chart of the week- MED:

MED- Chart of the Week

This stock has been a terrific cash-producer for many of us over the past few months. Note the technicals:

Price bars are at or above the uptrending 20-d ema (blue arrow)
Uptrending 100-d ema is below the shorter-term ema (red arrow)
MACD is positive (green oval)
Histogram is positive (red oval)
Slow stochastic oscillator is in the overbought range but holding (purple recatngle)
Volume is significant with all positive indicators (orange recangle with rounded corners- anyone know what this shape is called?)

Last Week’s Economic News:

A light but positive week of reports sums up the last few days. Retail sales increased by 1.3% from October, much higher than anticipated. Business inventories rose for the first time in over a year signifying a boost to the economy and the U.S. trade deficit narrowed in October as the economy continues to show signs of recovery. For the week, the S&P 500 rose slightly for a year-to-date return of 25%.

This Week’s Economic Reports:

Tuesday: Producer Price Index and Industrial Production
Wednesday: Consumer Price Index, New Residential Construction and info on the last FOMC meeting
Thursday: The Conference Board’s leading economic indicators

Video currently playing on the homepage (NEW!):

I hope you find this helpful as we approach expiration Friday:

Calculating Expiration Friday Exit Strategies using the Ellman Calculator

Cashing in on Covered Calls is now in KINDLE format:

http://www.amazon.com/s/ref=nb_ss?url=search-alias%3Dstripbooks&field-keywords=alan+ellman%2Fkindle&x=13&y=20

Wishing you a happy and healthy holiday season,

Alan and Linda

alan@thebluecollarinvestor.com

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Stock Option Chains: Open Interest and Volume