This week's mail brought this query from one of our Option Investor subscribers. This mail from my inbox seemed like a good topic to refresh the old knowledge bank with our readers. It may be also that my brain is on low partial shut-down holiday mode, but the topic is one that provides some useful information or a reminder to all us option traders:
"Hello Leigh, love reading your column. My question is on open interest. I've done some reading on it buy I can't find exactly what I'm looking for. Here are my questions:
1. How does volume impact open interest?
An option example:
Question 1: How does volume impact open interest?
Volume doesn't 'impact' Open Interest directly. Trading volume is of course always relative to the average or recent trading volume of the option in question. We want to know if today's volume is large or small relative to what has come before. Mostly, in technical analysis terms, volume will be looked at in terms of the price TREND. In a technically 'strong' trend, volume should expand in the DIRECTION of the price trend. But Open Interest also has a relationship to volume. Volume and Open Interest 'should' or will tend to move in SAME direction, as suggested below in the rules relating to the price trend.
In an uptrend, we expect volume to increase with prices. In a downtrend we anticipate that volume will increase on declining days, at least on balance. A large percentage change in price that's accompanied by larger than normal trading volume is a good indication of market strength in the direction of the change. Conversely, a large percentage increase/decrease in price accompanied by a relatively (relative to the prior average daily volume) low small trading volume is less likely to indicate a new price direction. In fact, it might indicate a possible reversal in the trend.
There are some rules of thumb that have been seen to have validity over the years for BOTH volume and Open Interest (OI):
Prices in an uptrend, with daily Volume and OI rising is interpreted as new money coming into the market (reflecting new buyers) and is considered bullish. If however, prices are rising on falling volume with Open Interest also declining, short sellers are assumed to be covering their positions and causing the rally. Money is therefore leaving the instrument in question and is considered bearish.
If prices are in a downtrend on increasing volume and open interest is on the rise, technical type traders figure that new money is coming into the market, showing aggressive new shorting. This scenario then suggests a continuation of a downtrend and a bearish condition.
**Lastly, if the volume trend and total open interest is declining along with prices, the decline is likely to being caused by disgruntled long position holders liquidating their positions. Technicians view this scenario as one of a declining trend but also being a 'strong' candidate for an upside reversal at some point, as the downtrend will end once all the sellers have sold their positions.
SUMMARY: OPEN INTEREST
When open interest is high at a market top, relative to what the average OI has been over the course of the trend and then prices fall dramatically, this situation is suggestive of a TOP, suggesting that all of the long position holders that bought near the top of the market are now in a loss position; and their panic will keep prices under significant pressure.
(Subscriber) Question #2:
The question was not asked here, but one way to use OI is to look at it relative to the Volume of options traded. When the volume exceeds the existing OI on a given day, this suggests that trading in that option was exceptionally high that day. OI can help you determine whether there is unusually high or low volume for any particular option.
Open Interest (OI) also of course gives you key information regarding the liquidity of an option. If there is no or very little OI for an option, there is or a very limited secondary 'market' for that option. When options have a large OI, it means they have a large number of buyers and sellers and an active secondary market will increase the odds of getting option orders filled at good prices. So, all other things being equal, the bigger the OI, the easier it will be to trade that option at a reasonable spread between the Bid and Ask.
(Subscriber) Question #3:
(Subscriber) Question #4:
There's not a lot that a large Open Interest can tell you when it's well above or below the current level of the underlying index in the case of the S&P 500 (SPX), except that traders are anticipating a large move before expiration.
Martin Pring, a well-known technical analyst, wrote a good SUMMARY of what Open Interest can possibly 'tell' us about the future price direction as follows (some points are all/partial repeats):
GOOD TRADING SUCCESS!
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