Trading Volume, Open Interest and Volatility

We look at these essential elements in the options world to determine whether to enter a position or wait. As traders of the SPDR ETF Trust, SPY, we monitor these indicators closely, sometimes even choosing to sit on our hands until the numbers return to a tradeable range. Remember: it’s better to not be in a trade wishing you were than to be in a trade wishing you weren’t.

Trading volume represents the total number of options contracts that are bought and sold during a specific period. This is one measure of liquidity and is updated continually. The higher the volume, the more liquid the market is, meaning that it is easier to buy or sell the asset without significantly impacting the price. This also facilitates tight bid/ask spreads, securing a more solid value for your options. You do not want your trade to affect the price but rather buy and sell into it.

As a side note, trades that can affect pricing, such as penny stocks, can lure you in with the promise of great returns, then leave you hanging when the perpetrator of the “pump and dump” cashes out for the high price, bringing the value of the stock down in its wake. Not only do you lose, but a review of the stock’s history leaves you impressed that your “guru” knew that all along, yet he was the instigator of separating you from your funds. More on that later.

Open interest represents the total number of outstanding contracts that have not been settled or closed. It shows the number of active positions held by traders and is a key indicator of market activity and liquidity. If a trader buys an option, this indicator will rise. This benchmark, which is reported daily in the morning, measures market sentiment and can help confirm the strength of a trend. For example, increasing open interest on a rising strike price may indicate a strong uptrend. It also measures levels of support and resistance. I will often consider an option several strike prices out if the open interest is huge.

Volatility measures an asset’s bounciness. It is a statistical gauge associated with the dispersion of returns for a given security, either up or down. It is often measured from either the standard deviation or variance between those returns. In most cases, the higher the volatility, the riskier the security. In the standard Schwab Think or Swim platform that we use, we look at the implied volatility. My preference, although I may trade outside of these parameters, is generally in the 20% to 30% range. Anything higher and the risk of getting caught in the options squeeze increases. When the reason behind high volatility drops, so does the option price.

I like to combine these elements to determine better entry points. For example, if I am interested in calls, I would look to buy an option with high volume, generally over 1,000 contracts. It should have greater open interest to the upside and a reasonable implied volatility as suggested above. Any implied volatility less than 15 suggests I may have limited movement in the option, and I may have to settle for a lesser profit.

While we can never guarantee results, the more we reduce risk, the more likely we will profit from our trades. These are just some of the key items we discuss and teach. Join Jon and me every morning in our long-standing Trading Room. We can help you become a great trader and, hopefully, stay out of the danger zone. Jon and I have paid our dues to the market. Our goal now is to help protect you from market nuances you may not otherwise know.

Our other programs are designed to facilitate your need to trade.

The DTS Signal is an algo-based program that sends a particular option trade to your cell phone as a text message. Buy it immediately, establish your sell order and collect your rewards.

Our Pick of the Day provides a particular option to be bought at market open. Let us do the heavy lifting with both the DTS Signal and Pick of the Day, currently enjoying a roughly 90% success rate.

Just getting started? Our Inner Circle subscribers receive our Morning Market Assessment, daily follow-up report and invites to our interactive Wednesday night Meetups.

Please join us for our Intro to Trading/Week in Review, 8 p.m., ET, Sunday night. Register now.

Create great trades,

Hugh