The Options Clearing Corporation (OCC) administers and settles all trades in standardized options. The OCC technically is the buyer and seller of all options and guarantees the performance of each option, meaning the delivery of cash or shares upon exercise. One of the most basic things OCC does is to keep up with the number of contracts outstanding in each option series.

Open interest and how it is determined

Open interest is simply the net number of contracts of a particular option series outstanding (open) at any one time. Remember that an option contract usually (except in merger and in certain other recapitalization situations) covers 100 shares of the underlying stock. So an open interest of 125 contracts of a call series means that 12,500 shares are subject to calls in that series (125 x 100).

An option series is simply a unique option: for example, the Oracle Corp. December 12.50 call option is a unique call series with its own unique identifying symbol. Unlike shares of stock, which are tangible and fixed in number at any one time, options are created when they are sold. There is no theoretical limit on the number of contracts of any option series that could be open. The open interest in each option series simply is number of short and long positions existing, which have to be equal in number.

Example: The easiest way to think of this is to imagine a call series that has no contracts outstanding. If I sell 5 call contracts of this series, someone bought them, and the open interest would be 5. It is true that I would be short 5 calls, and the buyer would be long 5 calls, but the open interest would only be 5.

Short and long positions are not added together, which would double the number of contracts actually outstanding.

So what happens to open interest as option contracts trade in the market? It really depends on whether the contracts are traded to open or close a position. Every option trade is a buy or sell and is made to open or close, which is specified when the trade order is entered. You probably have noticed that when you run a covered call trade you are buying the stock and selling the calls to open. An option trade can be one of four types:

• Sell to open - creates a new short option position for the trader
• Buy to close - closes an existing short position
• Buy to open - creates a new long option position for the trader
• Sell to close - closes an existing long position

1. When both parties are opening new positions (one is selling to open and the other buying to open), open interest increases.
2. When both parties are closing existing positions (one is selling to close and the other buying to close), open interest decreases.
3. When one party to an option trade is opening a position and the other is closing a position, open interest will remain unchanged.

Open interest as a liquidity indicator

Other than the raw number of contracts open, does open interest really tell you anything? The answer is that it tells you quite a lot. The open interest tells you first of all how liquid the call series is at that time. The higher open interest is, the more demand there has been for the series and the more liquid it is.

Example: Assume that there are two companies whose stocks are similarly priced at about $15, yet the 15-strike calls on one stock has 125 open interest and the 15-strike calls on the other has an open interest of 3,125. Quite a difference, isn't it? One series is fairly liquid, the other not nearly as liquid.

If there are less than 500 contracts open, the call series is very illiquid, and we avoid it unless the stock is extremely attractive. We prefer there to be at least 1,000 open contracts. Over 2,500 open contracts we consider fairly liquid.

The real problem with lack of liquidity is that the bid and asked spreads on the options tend to be huge, frequently $0.20 or $0.25. Trading against that size spread will eat at profitability over the long term. Not only that, but if the stock falls and you have to buy back the short call to unwind the position or roll down to a lower-strike call, the huge spread will persist all the way down. It is not unusual on such calls that when the stock has dropped hard the call will be bid at zero or $.05 and the call still will cost you $0.25 or $0.30 to buy back. Now, that hurts.

Trade Tip: In this situation don't hesitate to bid $0.05 or $0.10 to buy back the calls, since sometimes the call holders will take it. But in very illiquid option series it is very tough to sell the option if you are long.

Keep in mind that stock price has quite a lot to do with open interest. The at-the-money (ATM) calls - where the stock price is at or very close to the strike price - usually get the most trading action. If a stock is priced at $15 and has been around that price for a while, one would expect the 15-strike calls to have the most open interest of the different call series for that stock. But if the stock had recently been trading at around $12 to $13 and had very recently moved up to $15, you would expect the 12.50 call to have significantly higher open interest than the 15 call. Thus the fact that an ATM call series has little open interest due to a recent stock price move is not of concern, if the formerly ATM call did have decent liquidity. However, if there is low volume in the newly-ATM strike, you may have trouble getting good fills on a covered call trade.

Volume in the call series also is to be considered. For example, if there are 1,000 contracts open in a call, but the volume is 5 contracts daily being traded, there is depth in the calls but not much liquidity, so the fills on trade orders might not be that good. The best fills will come consistently in calls that are deep (high open interest) and liquid (high volume). Just remember that the market will forgive a lot if there is deep open interest.

Open interest as a directional indicator

As noted above, the at-the-money (ATM) calls normally will have the most open interest. The reason is that the ATM calls in every stock historically pay the most money and represent the best value. The market generally does not know or even have a strong feeling about which way the stock's price will likely move before expiration, or if it will move. Look at it this way: if a stock trades at $15 and you expect the price to increase, doesn't it make the most sense to buy the 15 call and lock in the ability to buy it at $15 after it moves? Of course. If you buy the 17.50 call you pay less for the call, but the stock has to make a real move by expiration before the call will become more valuable and can yield a profit. But any move up will immediately increase the 15 call's value, since once it is in the money it should move up dollar-for-dollar with the stock.

Thus, when the ATM call series doesn't have the highest open interest, you should take a quick look and see why. The answer most commonly is that the stock price has moved, and the call series that should be getting the action hasn't yet increased open interest to the same level. If the stock price has not moved recently and most of the open interest is in a call series that isn't at the money, what is the market telling you? The table below indicates how we read the tea leaves. By "deep" in or out of the money, we are referring to strikes that are more than 5% in or out of the money.

In the final analysis, open interest is just another indicator - but one well worth looking at.

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