Open Interest is the number of contracts open (outstanding) in a unique option series (Example: the Microsoft DEC 30 Call). Open interest (OI) is the best indicator or market liquidity in stock options. Where open interest is high, at least a few thousand contracts, bid/ask spreads will be tighter and slippage in trade fills will be less.
Open interest generally swells in the same direction as a true accumulation (net buying) or distribution (selloff) in the underlying stock. Increasing open interest in calls confirms a stock’s advance, and increasing open interest in puts confirms a downtrend. There will also be some swelling of open interest in calls and puts that are ATM or slightly ITM.
TRADING NOTE: Making use of OI information presupposes that you use a charting program that will chart option series, since the free charting services available on the web usually will not chart options. The chart should be set up with an OI histogram for the option series under the stock’s price chart, since our goal is to compare OI levels with stock price movement and stock volume.
Interpreting Open Interest
Here are the basic rules for interpreting changes in open interest levels in OTM calls and puts in light of the stock’s movement, when the stock is in an uptrend or downtrend:
- Uptrend, Growing OI in calls – confirms strength of stock’s advance
- Uptrend, Declining OI in calls – bearish divergence from advance
- Uptrend, Flat OI in calls – slightly bearish, not confirming stock’s advance
- Downtrend, Growing OI in puts – confirms strength of stock’s decline
- Downtrend, Declining OI in puts – slightly bullish divergence from decline
- Downtrend, Flat OI in puts – very slightly bullish; not confirming decline
Thus growing open interest in the OTM and ITM options tends to confirm the stock’s continued movement in the same direction. As options writer John Summa put it well, it means that market players (who have been right about the stock up to this point) are still placing bets on a continuation in the same direction. Falling open interest, on the other hand, is bearish because more players are leaving the game than entering it. It means that the market players who have been right up to now are taking money off the table and are not being replaced by new players.
A combination of price uptrend on volume and swelling open interest in the OTM and ATM calls augurs well for writing OTM calls on the stock, because new players still are coming into the game.
Flattened open interest may or may not be a divergence; certainly it does not confirm the stock’s trend. When the volume in the ATM and OTM call series is good but open interest remains essentially flat, it means that many call holders are buying to close (leaving the game) and there is just enough call buying to keep open interest from actually declining.
Ideally, a strong trend in the stock should be confirmed by both an uptrend in stock volume and in open interest. Changes in the open interest level are not really a primary indicator, but they can be a strong confirming signal. When changes in the open interest level are matching stock volume, the signal is stronger and more reliable.
Many times after a real correction in the stock, volume coming off the swing low will be flat or even declining. This is a bearish divergence, but it is very common – swelling open interest in the ATM and OTM calls would help make the bullish case. After all, if volume is not driving the stock higher and speculators aren’t rushing into the calls, the bullish case lacks some steam.
Figure 7.16: BJS – Open Interest in the $32.50 Calls
Figure 7.16 shows the open interest for the Dec-2006 $32.50 Calls on BJS Services (BJS) growing strongly through November 2006. The stock prices for BJS are overlaid on the candlestick price chart for the calls. During October and November BJS had come off a $25.55 low to slightly over $34 at the end of November.
During November, the open interest in the calls exploded, confirming the brief uptrend. But what really is being confirmed of course is the buying (speculative) interest in BJS during this period. Some of the call-buying frenzy may also have been fueled by shorts hedging their positions.
But by the time open interest had swelled to such proportions, the stock move was running on fumes, because BJS sold off heavily in December.
Thus expanding call open interest on a sharp stock rise certainly is no guarantee of longevity. The irony is that on a truly short-lived move of a month or so, by the time we can establish strong open interest growth, the move may be out of gas. The following segment on consulting multiple chart time frames will address this issue.
At some point in the stock’s advance, the longs who have been in the calls for a while will start taking profits. Thus a falling-off of the open interest tells us that those older longs are taking profits, and they have been right so far.
Changes in open interest generally will be more pronounced in the current expiration month because delta is higher; and much less so in the next or further months. The closer we are to current expiration, the more activity will be seen in next month’s options. However, where premium is high due to an impending volatility event in the next option month, there may be more option activity in next month’s options because the market expects the action then; not in the current month. This will particularly be the case where options are not heavily traded on the underlying stock. Indeed, some trading systems look for a large, unexplained increase in open interest as an insider-trading signal that an event is about to occur.
By no means do speculators always buy cheaper OTM options. Many buy ATM or slightly ITM options, which are more expensive but more likely to yield a profit due their higher delta. An ITM option begins winning almost immediately as the stock continues to move, assuming no change in the option’s delta or implied volatility.
OTM premiums, on the other hand, are much slower to respond to the stock’s continued movement due to their low delta. For this reason, much of the speculation happens in the ATM, and only a small portion in ITM options. The ITM calls are the first ones closed, because they often were bought earlier and speculators are taking profits.
Therefore when charting open interest, focus on the ATM and nearest OTM calls for the current month. As noted, an explosion in the open interest for illiquid options most definitely indicates something is up. There are trading systems that look for double the normal volume in puts and calls close to the money as a sign of precisely that.
If the stock is approaching a trend line, or the 50- or 200-day moving average from underneath, be wary about a call write. The trend line or moving average acts as a resistance level and poses a very real chance that the stock will fail there and retreat.
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