Last Updated on 8 January, 2022 by Samuelsson
Technical analysis is a key element in financial trading, and apart from the price itself, two of the most commonly used metrics in technical analysis, especially in the futures and options markets, are open interest and trading volume. While those two data points show the level of market liquidity, they mean different things. What is the difference between volume and open interests?
Volume measures the total number of contracts that have been traded on any particular trading day, while open interest measures the total number of contracts of a specified expiration date that are open — held by traders and investors in active positions. In other words, while volume represents the total activity in a particular contract, open interest tells traders what type of activity it is, specifically the open contracts. The volume covers both the open interest and the liquidated, exercised, and expired contracts.
In this post, we’ll cover the following:
- What is the daily trading volume?
- What is open interest?
- How volume is different from open interest
- How to use these metrics in trading options and futures
What is daily trading volume?
Trading volume is a measure of the number of shares or contracts traded in a given period. So, the day’s trading volume is the total number of shares or contracts traded that day. It quantifies the level of activity for a specific stock (in the equity market) or contract (in options and futures markets). Each transaction is factored in for the computation of the daily volume.
Thus, trading volume is one of the best measures for gauging the market activity for a particular security and shows directly its market liquidity value. When the trading volume is higher, it reflects that other investors are actively interested in a particular security, and subsequently, those orders would be executed.
In the stock market, if the trading volume is higher along with a price change, this indicates that there is a favorable opportunity to invest as the volume metric establishes a direction, which helps investors in making trading decisions. While the volume can give insight into the strength of the current price movement, it has no impact on the number of shares of stock that are being traded.
However, in the options market, volume in a particular contract can either be for open or closed out contracts. Changes in the volume are what make option prices move up or down. It is also a great way for option traders to gauge the liquidity of a particular contract. The higher the volume, the more liquidity the contract has. Higher liquidity means it is easier to enter and exit positions, and also, the spread between the bid and ask prices will likely be lower.
However, note that trading volume is relative, so it needs to be compared to the average daily volume of the underlying stock. If there’s a significant change in price accompanied by higher-than-normal volume, it could be a solid indication of market sentiment in the direction of the change. But, if a big price increase is accompanied by low trading volume, the price move may seem unreliable and could be a sign that a price reversal is coming soon.
Trading volume example
Let’s assume that not a single contract of a futures contract with March 2022 expiration traded on a specified day. The trading volume for that day would be 0. Let’s also assume that on the next trading day, an investor buys 20 contracts of that March 2022 contract in the morning and liquidates 5 of those contracts in the evening, and there are no other trades that day. In this case, the day’s trading volume would be 25 contracts.
Why trading volume matters
The trading volume metric documents the number of contracts that are exchanged between buyers and sellers on a given trading day. It covers the level of activity for a particular contract; each transaction — regardless of whether it’s an opening or closing transaction — counts toward the daily volume.
The greater the volume, the more the activity in a contract, which is why investors usually view volume as an indicator of the strength of a particular price movement. Moreover, volume is an important measure of liquidity. Thus, when the volume is high, there is greater liquidity in the contract, which is desirable for short-term traders, as it means that there is an abundance of buyers and sellers in the market.
What is open interest?
Open interest is a metric that is unique to the options and futures markets. Unlike volume, open interest is a measure of the total number of open contracts for a given expiration date. While volume represents the total activity in a particular contract, open interest tells traders what type of activity it is. It is one of the data fields on most option quote displays, along with bid price, ask price, volume, and implied volatility.
Open interest indicates the total number of option contracts that are currently out there. These are contracts that have been traded but not yet liquidated by an offsetting trade or an exercise or assignment. So, when new contracts are opened, open interest rises, but when they are closed or liquidated, open interest falls. However, unlike trading volume, open interest is not updated during the trading day.
Rising open interest is a great indication that money is flowing into a particular contract. In fact, as a general rule of thumb, contracts with open interest of fewer than 500 contracts may not have enough liquidity to enter and exit easily.
To sum up, open interest is used as a measure of liquidity alongside market activity, and like any other security traded in the market, open interest is subject to volatile market fluctuations. It represents the contracts in the market that are not yet closed; it increases when new contracts are created or opened. The increased number of open interests would mean that there are more buyers and sellers for a particular security. Similarly, open interest decreases when positions in the existing contracts are closed out by buyers and sellers — a lower open interest indicates a disinterest by investors in opening new positions.
Open interest example
Let’s say that on day 1, not a single contract of a futures contract with March 2022 expiration was opened on a particular trading day. The open interest for that day would be 0.
Then on day 2, let’s say that an investor buys 20 contracts of that March 2022 contract. The open interest would then be 20. Now, assuming that on day 3, 15 more contracts are opened and 5 contracts are liquidated, the open interest would increase by 10 (15-5). So, the open interest on the third day is 30.
Why open interest matters
Some options traders ignore open interest because the data when you are looking at the total open interest of an option, there is no way of knowing whether the options were bought or sold. Nonetheless, this metric has a lot to offer. A common way to use open interest is to compare it to the volume of contracts traded: the volume exceeding the existing open interest on a given day suggests that trading in that option was exceptionally high that day.
Another way to look at open interest is in the aspect of liquidity in a contract. You can use open interest to have an idea about the liquidity in an option contract: if there is no open interest in an option, there is no secondary market for that option. But a significant open interest in an option contract means there are a large number of buyers and sellers out there. All other things being equal, the bigger the open interest, the easier it will be to trade that option at a reasonable spread between the bid and ask — an active secondary market increases the odds of getting option orders filled at good prices.
For instance, let’s assume you look at options on Amazon.com and see the open interest is 12,000. This implies that the market in Amazon.com options is active and there may be a lot of investors in the marketplace who want to trade. With the bid price of the option being $1 and the offer price of the option being $1.05, you can likely buy one call option contract at the mid-market price. However, if the open interest is 1, it means there is very little open interest in those call options. So, there is no secondary market because there are very few interested buyers and sellers. In this case, it would be difficult to enter and exit those options at good prices.
Interpreting open interest data
There are different ways to interpret open interest in light of what the price is doing. Let’s consider some scenarios to see how the open interest data can be used to understand what might be happening in the market.
- Rising prices during an uptrend with open interest also rising: This implies that new positions are being opened, so new money is coming into the market. It could be a sign of bullish sentiment if the increase in open interest is being fueled by long positions.
- Rising prices during an uptrend but open interest on the decline: This could indicate that money is leaving the marketplace. It might be a bearish sign.
- Falling prices in a downtrend while open interest is on the rise: This might suggest that new money is coming into the market on the short side. It could be a bearish sign, as it is consistent with a continuing downtrend.
- Falling prices in a downtrend while open interest is on the decline: This could indicate that holders are being forced to liquidate their positions, which would be a bearish sign. It often shows that a selling climax could be on the near-term horizon.
- A high level of open interest while prices are dropping sharply during a market top: This scenario could imply a bearish sign if holders who bought near the top are now losing money; it could potentially cause an environment of panic selling.
How volume is different from open interest
As you can see from our discussion so far, open interest and volume help options and futures traders to assess the market liquidity and market activities. However, both metrics are significant in different ways:
- Open interest considers the number of contracts in options and futures contracts that are active (or not settled) at a given time, while volume covers all contracts traded at any given period, whether active or inactive.
- While open interest is highly volatile because it is cumulative (subject to dynamic increases and decreases in active contracts) and gives the overall picture of active interest in a particular security, volume measures the number of trades for a specific period.
- Trading volume data is continuously updated all through the trading day, while the changes in open interest values are not frequently updated — the total open interest is calculated and maintained by the securities exchange at the end of each trading day.
How to use these metrics in trading options and futures
Combining volume and open interest might help you in analyzing the options market to find trading signals. Here’s how to use them to identify potential options trading opportunities:
- If prices are rising and open interest in a call contract is also rising, it could be a bullish signal that buyers are establishing new long positions. So, you may look for long opportunities.
- If prices are rising but open interest in a call contract is falling, it could be a bearish signal that traders are losing conviction in the bullish trend. You might wait to see what is going on first.
- If prices are falling but put contract open interest is rising, it could be a bearish signal that traders are opening new short positions. You may want to go short.
- If prices are falling but open interest in call contracts is also falling, call holders may be getting forced out of their positions by margin calls, which could be a bearish short-term indicator but also an indication that a bottom could be near. It’s better to wait.
As a trader, you have to use every piece of information at your disposal to ensure an accurate analysis of the market. Open Interest and Volume are both important resources for your market analysis if you’re trading options or futures.