Lessons from the Pros


Options for Newbies – Open Interest

In last week’s article called Market Makers and the Option Chain, which you can review here, I talked about option volume, and began discussing open interest. Volume is the number of contracts traded during a certain period of time. In any option chain, we can see the figures for the current day’s volume. Next to the Volume column, is another column called Open Interest. Today’s article describes what Open Interest is, and how it changes. Along the way are some important points about how the options market works.

Continuing our example from last time, we looked at selling a single call option contract, on Apple Inc. stock, at a strike price of $640 per share, with an expiration of January, 2015.  Our transaction to sell that call is the only transaction on those Jan ’15 640 calls for the day. Prior to our transaction, there was an Open Interest figure for that particular contract of 202.

My lonely single-contract transaction would result in a volume for the day of 1. My parting question was this: How will the Open Interest change? The answer is that it depends. The Open Interest might stay the same (202); or it might increase by one contract, to 203. Which of those happens depends on the previous situation of the person to whom I sold it.  That is today’s subject.

To understand how Open Interest changes, bear in mind that for every option contract seller, there must be a buyer in order for the transaction to take place. In our example, I would have been able to get my order to sell a contract filled immediately, even if no other retail traders were participating.  That’s because option market makers are always standing by, ready to fill incoming orders at their posted prices.  That is their business. They literally make the market – if I want to sell something and they are posting a quote to buy it, then I have someone to sell it to. They are my buyer, even if no one else is ready to buy at that time. (The quantity that I could sell at any given time is not unlimited – the market makers are not required to buy or sell unlimited quantities at their posted prices).

So for all practical purposes, as long as there is a quoted bid and ask price in the option chain, I can always buy or sell some quantity of contracts instantly. There will always be someone to whom I can sell or from whom I can buy.  The counterparty may be another trader, or a market maker.

In our example, I am selling a call option that I do not own.  The option lingo for that is Selling to Open. After selling to open this option position, I would be short that option.  To close out a short option position, I might eventually buy to close. (Or I might not, if the option has no value at expiration.  In that case, I could simply let the option expire.  My obligation expires with it).

Selling to open means getting paid for the option immediately; and taking on the obligation that is the flip side of the option buyer’s right.  In the case of the Jan ’15 640 calls, I’m getting paid $134.10 per share today.  In return, I’m taking on the obligation to deliver Apple stock, in exchange for an additional $640 per share, at any time between now and the third Friday in January, 2015.  The option buyer has the right to force me to do this whenever he chooses, by exercising the option. He is not obligated to do so, and ordinarily won’t unless that would be profitable for him.

I have Sold to Open this call. But is my buyer Buying to Open, or Buying to Close?  If, before buying this call from me, my buyer had no position in these calls, then he was Buying to Open. He owned no calls before; he bought one; and now he owns one. If that’s the case, then between the two of us, my buyer (who may or may not be a market maker – doesn’t matter) and I have just created an additional contract. The Open Interest will now be higher by that one contract, at a new value of 203.

The second and only remaining possibility is that my buyer was Buying to Close. This would be true if he had previously done what I just did – sold to open a Jan ’15 640 call that he did not then own. If so, he was already short one of these calls. In that case, in the current transaction, he was Buying to Close. He had been short one call; you could say that he had owned -1 calls. He bought one call from me to close out that short position.  He now owns -1, plus the one that he just bought from me, for a total of zero. His earlier short position has been offset.  My buyer’s position was closed out as mine was opened.

If this second possibility is the case, then I am Selling to Open while my buyer is Buying to Close. The open interest remains unchanged at 202 contracts.  The short position has just been transferred from my buyer to me, and there is no net change in the total number of contracts outstanding.

In summary, every transaction has a buyer and a seller. Each of them is either opening a position, or closing one. Here is the effect on Volume and Open Interest in the four possible transaction scenarios:

Buyer’s Action                  Seller’s Action           Volume  Open Int    Remarks

Buy to Open        –              Sell to Open                       1           +1           New contract created

Buy to Open        –              Sell to Close                       1             0          Obligation transferred

Buy to Close       –              Sell to Open                       1               0           Obligation transferred

Buy to Close       –              Sell to Close                       1             -1          Contract destroyed

From this table, we can now see that the Open Interest in any specific contract will change from time to time, and can either grow or shrink. On any particular day, even if there is a very large volume, at the end of the day the Open Interest could be smaller; or it could be larger. That depends on how many people were opening positions versus how many were closing them. Contracts are automatically created out of thin air as needed, and destroyed again as they are offset.

How is this information useful to us?

  1. We can always sell or buy an option, as long as there are prices quoted for it. We need not worry that there will be “no one there” to take the other side of our trades.
  2. We should trade options that have sizeable open interest figures. These are more likely to have others involved, besides just the market makers. That will make for smaller spreads.

That’s all for today. For comments or questions, contact me at rallen@tradingacademy.com.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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