What makes for liquidity? High volume, a narrow bid/ask spread and a large open interest.
I always advise my students and mentees to only trade option series that show good liquidity. Ease of exit in a position is more important than ease of entry. On the trading floor we used to speak of a ?Roach Motel Position??Easy to get in, impossible to get out.
What makes for liquidity? High volume, a narrow bid/ask spread and a large open interest. Today I?d like to look at that last one as it?s really very important.
Option open interest (OI) is the number of contracts outstanding in that particular option series. At the first listing of a new series following expiration, open interest is zero. Trader A buys 2 options from B and the OI is 2. Trader C buys 2 from D, the OI is now 4. B buys back 2 from C reducing the OI by 2. But, if B buys those two back from a new party, E, then the OI stays the same. Option exercise also reduces the OI by the number of contracts exercised. And, of course, on expiration the OI becomes zero.
Keep in mind that options, unlike stocks, are not securitized. Meaning, that while there is a fixed number of shares (the float) that can trade back and forth while not reducing the size of the float, option OI can rise to theoretically infinite levels.
This is good information for traders as a high OI means a large interest in that series which will create its own volume as these positions need to be unwound. Technical analysts would say? that rising OI reflects more new money flowing in and that argues for a continuation of an existing trend while falling OI indicates unwinding and the possible end of a trend.
During my many years of market-making experience I noticed that the expiration price? tended to be at the series with the greatest OI. It was almost as though the OI acting as a magnet, pulling the underlying value to that strike price.
OI figures can be found on any decent trading platform or publications such as the Wall Street Journal. It behooves any serious trader to closely monitor the OI. And I recommend that new positions only be opened in liquid option series with a high open interest.