Why Options Open Interest is More Important than Stock Selection

Option Open InterestLet me just start out by saying everything should start with picking the right stock for any investment. Whether you are just looking to buy and hold or if you are implementing any strategy using stock options; the stock you buy is top priority. Once you enter the world of options there are other things that can top how great of a stock you chose. One of those things is an option’s open interest.

 

What is Open Interest?

 

Open interest is how many options contracts are still open or have yet to be closed out. Every time you enter an options trade with a sell to open or buy to open order, you are adding to the open interest. It’s important to remember that the open interest tracks the number of option contracts that have not been closed out and not the number of total trades that took place, known as volume. For example if you placed one trade for 10 contracts of Google (GOOG) you would have increased the open interest count by 10. Later on when you decide to close out that position you would be decreasing the open interest by 10.

 

Options volume on the other hand is merely the number of contracts that have traded in any given time period. If you look at the example above where we bought 10 GOOG contracts and then later sold those same 10 contracts, the volume on those two trades would be 20 since 20 contracts were either bought or sold.

 

One thing you can’t tell however with both open interest and the option volume is whether those trades were buy or sell orders. You only know that there are outstanding trades by looking at open interest. The volume tells you how many contracts have been traded.

 

So Why is Open Interest So Important?

 

After you have done your research and homework on the company you want to own shares of you are ready to pick the option that you want to either buy or sell. If you’re looking to sell a covered call then obviously you will be selling a call option. Although with this option strategy you will not typically be looking to buy back the option, you do want to make sure that if you need to close out the position prior to options expiration, you can.

 

Each option will have it’s own open interest number. Typically you will see higher open interests for options that are currently near the price of the stock. This is not a rule however. Sometimes high open interest for different option strikes and different months can indicate what movement the market is expecting from that particular stock.

 

How Much Interest is Good Interest?

 

Let’s take a look at an option chain and see the actual open interest numbers. Below is an option chain for Edison International (EIX). It is the chain for the January 2014 expiration. Whether you are reading this before or after this option expires won’t matter for this example.

 

The option chain shows both the calls and puts for Edison International. Strikes from $40 to the $55 mark are shown in the image below. Right above the $40 strike you can see that EIX was trading at $46.22. To examine the volume and open interest let’s take a look at the call options, which are located on the left hand side of the options chain.

Edison International - EIX options chain for JAN 2014 expiration

Edison International – EIX JAN 2014 expiration

 

Let’s look at the $47.50 call option. If you look right under the word ‘Calls’ you will see OpInt, written in blue. This column is the open interest. Follow that column down to the $47.50 strike and you will see that there are 730 in open interest. In other words there are 730 call option contracts that have yet to be closed out, either with a buy to close or sell to close order. As you can see each call and put at each of the different strike prices has a different open interest.

 

Sometime you may come across an option that has a big fat zero in the open interest column. You don’t want to attempt to open a trade at this strike price. If there aren’t any open orders it can be difficult to close out a position. It can also make buying the options more expensive. Additionally, if a particular strike does not have much activity, the spread, or difference between the bid and the ask, can be very wide, eating away at potential profits.

 

What is the Ideal Number?

 

We’ve already established that you don’t want it to be zero. An ideal place to start is a strike with an open interest of 50. You can place trades with options that have less than that but I wouldn’t advise you to do so. There are thousands of options available, don’t make it harder than it has to be.

 

On the flip side, anything over 50 should be fair game, all else being equal. You are simply looking for an option that is frequently traded to give you the best price and the opportunity to liquidate your position should you feel the need to do so. For some stocks that are heavily traded, you can see open interest in the tens of thousands.

 

So before you hit that order button be sure you have checked to see if you have picked the right option or if you’ve just made a trade that you won’t be able to get out of.

 

Have you ever had a trade that you couldn’t get out of because of poor open interest? Leave a comment below.

                                                                   

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