Open interest vs Volume in option trading: Understanding key differences

Introduction

Imagine you’re at a crowded stock market event, observing the crowd’s behavior. Some people are trading frequently, while others are holding onto their positions. This difference is similar to understanding what is open interest versus volume in options trading. Open interest reflects the total number of active contracts that remain open, while volume indicates how many trades have been made within a specific period. Together, these metrics give traders insight into market sentiment and activity levels.

What is option volume in option trading?

Here’s how the option volume in option chain looks like:

Volume in options trading refers to the total number of contracts traded within a specific period, typically a day. It represents how many times an option contract changes hands in the market.

1. Volume as a measure of market activity

• Liquidity Indicator: High volume indicates a liquid market, meaning it’s easier to buy or sell options without significantly impacting the price.
• Trading Sentiment: Volume shows the level of interest in a particular option, reflecting traders’ sentiment about the underlying asset.

2. How volume works?

Volume is reset to zero at the start of each trading day. For instance, if a call option for Tata Motors with a strike price of ₹400 has a volume of 5,000, it means 5,000 contracts were traded that day.

3. Significance of volume in trading decisions

• High Volume Signals: A spike in volume often precedes significant price movements, indicating strong interest or news impacting the underlying stock.
• Low Volume Caution: Low volume suggests limited interest, which could lead to wider bid-ask spreads and more price slippage when entering or exiting positions.

What is open interest in options trading?

Here’s how the oi in option chain looks like:

Open interest represents the total number of outstanding option contracts that have not been settled or closed. Unlike volume, open interest is cumulative and reflects the total activity in a particular option over time.

1. Open interest as a measure of market participation

• Contract Tracking: Open interest tracks the number of existing contracts in the market, providing insight into the market’s depth.
• Market Confidence: High open interest suggests that more traders are holding positions, indicating confidence in the ongoing trend.

2. How open interest works?

Open interest increases when new contracts are created (when one trader opens a position and another takes the opposite side), and it decreases when contracts are closed out or expired. For example, if traders open 1,000 new contracts for a call option on Infosys, the open interest will increase by 1,000.

3. Significance of open interest in trading decisions

• Trend Confirmation: Rising open interest in conjunction with rising prices can confirm the strength of a trend, while declining open interest might signal trend exhaustion.
• Liquidity Considerations: Higher open interest typically means better liquidity, making it easier to enter or exit positions without significant price impact.

Key differences: Open interest vs volume

While both volume and open interest are important metrics in options trading, they serve different purposes and provide distinct insights into market activity.

1. Volume reflects daily trading activity

• Short-Term Focus: Volume provides a snapshot of market activity on a given day, making it useful for short-term traders looking to capitalize on daily price movements.
• Volatility Indicator: High volume can lead to increased volatility, as more traders actively enter and exit positions.

2. Open interest reflects cumulative market commitment

• Long-Term Focus: Open interest shows the overall participation in a particular option, helping traders gauge the sustainability of trends over time.
• Trend Strength Indicator: Rising open interest, combined with price movements, can indicate the strength of a trend, while declining open interest may suggest a lack of conviction among traders.

How Volume and Open interest interact?

Understanding how volume and open interest interact can provide valuable insights into market behavior and help traders make more informed decisions.

1. Volume increases without open interest change

• Example: If a trader buys and sells the same option contract within a day, it increases volume but doesn’t affect open interest, as no new contracts are created or existing ones closed.

2. Rising volume and open interest

• Example: A surge in both volume and open interest for a call option on HDFC Bank suggests that new positions are being established, possibly indicating strong bullish sentiment in the stock.

3. Rising volume, declining open interest

• Example: High volume accompanied by falling open interest might indicate that traders are closing existing positions, potentially signaling the end of a trend.

4. Low volume, high open interest

• Example: If a particular option contract has high open interest but low daily volume, it might suggest that traders are holding their positions, waiting for a significant event before making their next move.

Examples

Example 1: High volume with rising prices

Suppose a popular company like Infosys announces better-than-expected quarterly results. On the day of the announcement, the volume of call options with a strike price of ₹1,500 surges to 20,000 contracts. This spike in volume, combined with a rising stock price, indicates strong bullish sentiment, with traders expecting the stock to continue its upward trajectory.

Example 2: High open interest with a bullish trend

Imagine a scenario where open interest in Nifty 50 call options with a strike price of ₹18,000 steadily increases over several days, while the index also climbs. This combination suggests that traders are confident in the ongoing bullish trend, as more contracts are being created and held.

Example 3: Low volume with high open interest before expiry

Consider a situation where a particular put option on TCS has high open interest but low volume as it approaches expiry. This could indicate that traders are holding onto their positions, anticipating a significant market move before the option expires.

How traders use Volume and Open interest in strategies?

1. Identifying breakouts with volume

• Breakout Confirmation: Traders often look for breakouts in stock prices supported by high volume to confirm the move’s validity.
• Entry Points: High volume during a breakout can signal a good entry point, as it indicates strong interest in the new price level.

2. Using open interest to gauge trend strength

• Trend Following: Rising open interest during an uptrend suggests that the trend may continue, as more traders are participating.
• Reversals: Conversely, declining open interest might signal that a trend is losing momentum, prompting traders to prepare for a potential reversal.

3. Combining volume and open interest for options strategies

• Bullish Signals: A combination of rising volume and open interest in call options can indicate a strong bullish signal, suggesting that traders expect the underlying stock to rise.
• Bearish Signals: Rising volume and open interest in put options might signal bearish sentiment, with traders expecting the underlying stock to fall.

Common misconceptions about Volume and Open interest

1. High volume always means high open interest

Clarification: Volume and open interest are independent metrics. High volume doesn’t necessarily mean that open interest will increase, especially if most of the trades involve existing contracts being closed out.

2. Low volume means low market interest

Clarification: Low volume doesn’t always indicate low market interest. It could also mean that traders are holding their positions, waiting for a significant event or price level.

Conclusion

Understanding the differences between volume and open interest in options trading is essential for making informed trading decisions. Volume provides insight into daily market activity, while open interest offers a broader view of market participation over time.