Volume & Open Interest — Definition

Volume is the total number of transactions filled on each stock options contract for the day. Open Interest is the total number of open stock options positions floating in the market place that is yet to be closed.

Volume & Open Interest — Introduction

Volume & Open Interest are one of the aspects of stock options trading that continue to baffle options trading beginners all over the world. Volume is the ultimate measure of liquidity in stocks trading but an additional measure called Open Interest is introduced in stock options trading. This led to the common misunderstanding that open interest is the sole determinant of liquidity in options trading. Nothing can be further than the truth. We shall explore in this tutorial the correct method of determining liquidity in options trading.

Why Does Liquidity Matter In Stock Options Trading?

Before the roles of Volume and Open Interest in determining the liquidity of stock options contracts are explained, it is imperative to understand what liquidity is and why it matters in stock options trading. What liquidity of stock options contracts mean is how readily they can be bought and sold at the market price. Stock options contracts that are highly liquid, or heavily traded, can be instantly bought or sold at the prevailing market price easily and instantaneously while stock options contracts that are less liquid or thinly traded tend to take a long time to fill and at very disadvantageous prices.

As in any form of trading, it is best to trade highly liquid instruments. Highly liquid stock options contracts gets filled quickly at the prevailing ask price and have an extremely narrow bid ask spreads. This ensures that orders get filled at the price that you see in the market when you want to and that bid ask spread loss is reduced.

Stock options contracts that have low liquidity gets filled very slowly as it is difficult to find a buyer or a seller in the marketplace. As the risk to market makers selling low liquidity stock options contracts is fairly high, that risk is compensated by a wide bid ask spread that increases the loss sustained upfront. In fact, if you hold very low liquidity stock options, it may even be impossible to find a buyer for those options!

Early in my options trading years, I have ever bought very illiquid options and held them all the way to expiration simply because no market makers are willing to buy them from me.

The volume and open interest of each stock options contract provide an indication on their liquidity, making it important to completely understand them.