By Steve Papale
My first job when I was 16 was at McDonald’s. Like 1 out of 8 Americans I worked there at some point in my life. Fast forward nearly half a century and to me McDonald’s looks and tastes pretty much the same. I guess that’s a big part of their success – consistency. But there is one thing it seems they are changing – or updating. The Hamburgler is getting a makeover. Looking a little more like a video ready trench coat wearing rapper. I just hope they don’t change the fries. I love those just the way they are.
Many traders use volume and open interest to gauge things like liquidity, strike selection and even market direction. While there certainly can be value in looking at these indicators there are some things we should take into consideration when using them. Volume simply represents the number of contracts traded during the trading day.
If you and I trade a 10 lot of ABC 100 calls the volume is 10 for that trade. Collectively all the trades for the day account for the daily volume. Volume can spike for a variety of reasons including earnings, any micro or macro news event or speculation. Some use volume as an indicator of the direction for a particular stock.
For example, say an extreme amount of out of the money calls were purchased by a customer to open. That could be a bullish sign but it also could be a long delta position against a short delta position they may have somewhere else. It’s often hard to tell. Open interest can certainly be used as a way to gauge liquidity within an underlying and in some instances within a strike. However there are some important things to keep in mind.
First, in cash settled indexes like SPX, NDX and RUT there is no pin risk so that eliminates the need to close out strikes near the at the money at expiration. Open interest in those cases can remain high. Second, in European cash settled indexes and especially SPX, open interest at certain strikes can be inflated due to an institutional trade strategy called a box. This strategy is basically an interest rate play with no market risk. So what appears as large open interest at certain strikes can be part of a box with participants treating those strikes as flat. Remember too that even if market participants are long or short a strike, they will almost as happily trade the a strike close to a open interest strike as the strike itself, especially in cash settled options, to lower risk.