beginners corner

Open Interest and Volume plus Non-Standard Options

As covered call writers, we have all looked at options 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 – figure below) an equity that was in my portfolio at one time  (note the original option symbology):

Options Chain for MELI

Current market price: $48.59

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 segment 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 option contracts that are open or outstanding on a particular day. This number is cumulative. 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 (see the chart below):

Mathematics of Vol and Open Interest

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 existing short position
  • Sell to Close (STC)- Decreases open interest by closing an existing 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

Mathematics of open interest

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. Open interest is generally a higher number than Volume because it is cumulative whereas volume is reset to zero at the beginning of each trading day.

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 chapter, the greater the open interest, the more favorable the bid-ask spread is likely to be. Open interest of 100 contracts or less is thought to have relatively thin liquidity. I like to see an OI of at least 100 contracts and/or a reasonable bid-ask spread ($.30 or less). Keep in mind that a bid-ask spread of greater than $.10 can oftentimes be negotiated down by “playing the bid-ask spread”.

One time cash dividends and adjusted strike prices: From time to time, we will notice options chains with oddball (non-standard) strike prices resulting from one-time cash dividend distribution. For a strike price to be changed as a result of a dividend two criteria must be met:

  • It must be a one-time only distribution
  • The dividend must be for more than 12 1/2 cents.

Last year, GES declared such a dividend, this one for $2. It went ex-dividend on December 6th and that is when we saw  the option strike prices reflect this dividend. Here is a chart showing the strikes before and after:

GES- Strike price adjustments

A free site where you can access information on contract adjustments is:

http://www.cboe.com/tradtool/contracts.aspx

 

LAST CHANCE TO SAVE $100:

The introductory pricing for our new DVD Program with Companion Workbook ends June 30th. The current special price of $295 returns to the original $395 and the package of the DVD Program with our latest book (“Encyclopedia…”) returns to $419 from the current discounted price of $319. We are proud to provide our members with the most comprehensive amount of information on the subject of covered call writing for the lowest prices. Premium members be sure to enter the Blue Collar Store from your premium site to benefit from your 10% discount. Here is a link to an informational video:

/store/

 

Upcoming events:

1- This coming Tuesday June 12th: I will be the keynote speaker for the New York City Private Investors Group at the ING Direct Cafe:

To sign up (seating is limited):

http://www.meetup.com/NYCPrivateInvestors/events/49668332/?a=ea1_grp&rv=ea1&_af_eid=49668332&_af=event

Time: 6PM to 7:30 PM

Admission is FREE and non-members are welcome.

2- September, 2012- Las Vegas: I’ve been invited to speak at an options trading event at the Paris Hotel in Las Vegas. Details to follow.

3- Financial Survival Network Radio Interview: On Friday, I was interviewed by Kerry Lutz of The Financial Survival Network about using covered call writing in a volatile and bearish market environment:

http://financialsurvivalnetwork.com/

 

Market tone:

This week’s reports were mixed but the market reacted positively:

  • The US trade deficit declined to $50.1 billion but concerns over China’s handling of the impact of the European crisis remains a major concern
  • The Beige Book showed modest expansion between early April and late May with continued strength in the manufacturing sector
  • Nonfarm business productivity fell in the 1st quarter by 0.9% more than the 0.6% expected
  • Consumer credit grew by $6.5 billion in April for the 8th straight month, but less than the $13.2 billion anticipated
  • Growth in the service sector grew to 53.7 in May but less than the 53.9 expected
  • Factory orders fell by 0.6% in April while a positive figure of + 0.4% was predicted

For the week, the S&P 500 rose by 3.7% for a year-to-date return of 6.4%, including dividends.

The past 3 months have been challenging for investors but June is off to a positive start:

Market tone 6-8-12

Summary:

IBD: Market in correction

BCI: Cautiously bullish on the US economy but hedging our covered call positions with low-beta securities and selling in-the-money strikes. ETFs are also considered good underlying choices in this environment.

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

Tags:

About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

Connect With Us

To send us an email, contact us here. Subscribe to our e-mail newsletter or RSS feed to receive updates. Contact us by phone at 866-892-2187. Additionally you can also find us on any of the social networks below:

19 Responses to “Open Interest and Volume plus Non-Standard Options”

  1. Barry B June 9, 2012 11:50 am #

    Premium Members,

    The Weekly Report for 06-08-12 has been uploaded to the Premium Member website and is available for download.

    Best,

    Barry and The BCI Team

  2. Jerry Barnes June 10, 2012 1:52 pm #

    Speaking of volatility and it’s increase of late, some of the stocks making the BCI Passed All Screens list have gap-ups in their price charts. Is a gap-up cause-for-pause with a stock? Do stocks frequently backfill to cover the gap?

    Thanks,
    Jerry

    • Alan Ellman June 10, 2012 6:23 pm #

      Jerry,

      Initially, a gap-up is an event that needs to be watched. The most common cause would be a positive earnings report. In my books and DVDs I recommend waiting until the price settles before entering a position with such an equity. Then depending on market conditions I would have no problem using an equity of this nature. In a bull market environment, I would use out-of-the-money strikes. In normal market or volatile conditions I would favor in-the-money strikes. As an example, I created a chart for ULTA which gapped-up from $87.50 as high as $98 after the last ER. The next day, the price settled around $93.50 which would be an acceptable entry point if this stock met your needs. (Click on image to enlarge and use the back arrow to return to this blog).

      Alan

  3. Debbie June 10, 2012 6:02 pm #

    Alan or barry,

    On this week’s stock list I see QCOR is listed as being on the list for one week. I know I’ve seen it on the list in the past. Please explain. Thanks a lot.

    Debbie

    • Barry B June 10, 2012 7:11 pm #

      Debbie,

      You are right…QCOR has been on the Running List in the past and then came off the list (when the stock fails to pass our criteria for three weeks in a row). Since QCOR was removed recently, we start all over counting the weeks it has passed our criteria. In this case, this is the first week it made it since coming off the list. Hopefully, it will be there for a long time… :).

      Best,

      Barry

  4. Alan Ellman June 11, 2012 5:49 am #

    Running list stocks in the news: HA:

    Hawaiian Holdings (airline company) reported 1st quarter earnings on April 24th with earnings of 6 cents per share compared to estimates of a loss of 3 cents per share. A year ago, it lost 6 cents per share. Revenues per available seat mile rose 6.5%. It is also a cash rich company with $376 million cash on hand. May traffic stats showed passengers transported up 6% year to year.

    Analyst estimates for 2012 has moved up to $1.30 from $1.26 equating to a 53.4% growth rate. This is also a fairly valued stock with a PE ratio under 5 (industry peers @ 8.4), a price-to-sales ratio @ 0.2 (under 1 = value) and a price-to-book of 1.3 (under 3 = value).

    Our premium watch list shows an industry segment rank of “A” and a beta of 1.21 with the next projected ER date of 7-26-12.

    Alan

  5. Alan Ellman June 11, 2012 11:36 am #

    Rebroadcast of Business Authors Show interview: June 11th:

    http://www.TheBusinessAuthorsShow.com

  6. Alan Ellman June 11, 2012 3:01 pm #

    Wash Sale (offsite) Q&A from today:

    Good morning

    I know that you say to sell the options in a tax free account, but for me this is not practical. Therefore this question. I buy 100 ABC at 71 and sell 1 July 70 for $2.00. On July option Friday the price of ABC is 71 and the stock is called and I lose $100 on the stock. Can I buy another 100 shares for the August contract and sell another in the money or a OTM contract and not have to worry about a wash sale.

    Or- I buy 200 ABC at 71 and sell 1 ITM July 70 contract for $2 and a July 73 contract for $1. On option Friday the price of ABC is $74 so, on the stock, I lose on the July 70 option, but win on the July 73 option. Would the IRS (and Schwab) consider this a wash sale?

    Thanks

    _________________________________________________

    Response (verified by Owen Sargent, CPA):

    Example 1: It’s not a wash sale because it is not a loss. He bought the stock for $71. His gross proceeds on the sale are $72 ($70 strike plus $2 option premium). He has a $1 gain on the stock sale. There is no such thing as a wash sale gain.

    Example 2: It’s still not a wash sale because it’s still not a loss. Both contracts were called. You have a $1 gain on the shares called under the $70 strike ($70 + $2 – $71), and a $3 gain under the $73 strike ($73 + $1 – $71).

    IRS Publication 550, page 62.

    Alan

    • Alan Ellman June 12, 2012 8:38 pm #

      Follow-up Q&A:

      One last question. If you roll out and down, are you safe if the total of all the premiums for ABC you have received plus the amount you receive if the stock is called at the new lower strike price is more than the original cost of ABC?

      Response conmfirmed by Owen:

      If you roll out and down you have a completed capital gain transaction. The original option you sold has been repurchased. Done. Calculate the gain or loss on the option and report it on Schedule D.

      Now you have a new option trade. If the option is called, it becomes part of the stock trade. If the new option expires, or is repurchased, it has another gain or loss to be reported.

      You do NOT add the option premiums together to report on Schedule D. You may keep track of what you made on that block of stock for you own information, but that has nothing to do with how it is reported for tax purposes.

      Alan

  7. Alan Ellman June 11, 2012 5:35 pm #

    UA:

    Announced a 2-for-1 stock split with additional shares distributed on July 9th. The number of shares will double with current market value cut in half. Those who sold July contracts or will sell (not currently on our watch list but was a few weeks ago) will have sold twice as many contracts at one half the original strike price. Check chapter 12 of “Encyclopedia….” for more detailed informastion on stock splits.

    Alan

  8. Alan Ellman June 12, 2012 12:38 pm #

    Running list stocks in the news: ULTA:

    On June 5th ULTA reported a stellar 1st quarter ER with earnings up 45.9% year-over-year and net sales up 22.8%. Both figures were well ahead of management guidance. Operating income also rose by 47.1%. As a result, analysts guidance has been rising to an upside of 34% over 2011. The return on equity (ROE) is at 23.6%, above the industry average of 14%. Our premium running list shows an industry segment rank of “A”, a beta of 1.11 and the next projected ER for 9-4-12.

    Alan

  9. Carol June 13, 2012 7:24 am #

    When would you start your new positions for the July contracts? Should I wait for this weeks new stock report?

    Thank you.

    Carol

    • Alan Ellman June 13, 2012 12:22 pm #

      Carol,

      On expiration week, I will roll options on Thursday or Friday. For new positions I DO wait for publication of the latest stock and ETF reports to enter the following week.

      Alan

  10. Alan Ellman June 13, 2012 8:36 am #

    Thanks to our members who attended my seminar in NYC last night and to the group leader for her review:

    http://www.meetup.com/NYCPrivateInvestors/events/49668332/

  11. Stan June 14, 2012 7:23 am #

    You responded to carol that you roll out on Thursday or Friday. Is your goal still 2-4%? Thanks for sharing your knowledge.

    Stan

    • Alan Ellman June 14, 2012 4:35 pm #

      Stan,

      Yes my goals remain the same: 2-4% for stocks and 1-2% for ETFs in normal market conditions. When considering rolling strategies your choice is to “allow” assignment or roll. If you still like the underlying security and the returns meet your goals, rolling makes sense. If not, allow assignment and use the cash to enter a new positions.

      Alan

  12. owencpa June 14, 2012 10:15 am #

    Alan has been sending me some email queries from some of you (see #6 above). I thought I would address the reporting issue again. The best source of information on how to treat an option “closing” trade is the IRS Publication 550, page 62. Everbody should print the page and tape it their transaction notebook.

    http://www.irs.gov/pub/irs-pdf/p550.pdf

    Here’s the thing. If you buy and sell and sell an option, it a complete transaction, just as if you bought and sold a stock. It does not matter if you sold the option BEFORE you bought it (that is a short sale). You still have a purchase and a sale and, therefore, a gain or a loss.

    The real issue is when an option is exercised. If you buy or sell a put, and it is exercised it to force the seller ( the IRS publication uses the term “writer”) to buy the stock, or you buy or sell a call, and it is exercised, the option premium BECOMES PART OF THE STOCK TRANSACTION. The option vanishes into the stock, never to be reported by itself. Example: I buy XYZ stock for $28 and sell the JUN XYZ $30 call for $2.

    By next Friday one fo three things will have happened.

    1) I will have bought back the option for a closing transaction that will create a short term gain or loss.

    2) The option will expire worthless for a short term gain, and I will still own the stock with a cost of $28.

    3) the option will be exercised because the stock is $30, or above. At that point I have only ONE transaction to report: Ibought 100 XYZ for $2,800. I sold 100 XYZ for $3,200. The option premium I received is added to the proceeds of the stock sale ($30 + $2). Now, if that stock has been gathering dust for more than 1 year when it is called away, the gain is long term. If not, it is short term. The length of time you were shorth the call is ignored. The option becomes part of the stock and vanishes.

    Now, all this said, if you are trading in your retirement account, none of the above matters. The only thing that matters is your account balance is bigger tomorrow than it was yesterday and you are a few dollars closer to telling your boss you quit.

    • Steve Z June 14, 2012 6:57 pm #

      Owen, EXCELLENT explanation! Thanks. Steve

  13. Alan Ellman June 14, 2012 4:32 pm #

    Premium members:

    This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site.

    For your convenience, here is the link to login to the premium site:

    https://www.thebluecollarinvestor.com/member/login.php

    Not a premium member? Check out this link:

    https://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

Leave a Reply

Optionally add an image (JPEG only)