Open Interest

An adviser is considering a hedge using an option series with very low open interest. The chief practical concern is that

1. A.the Options Clearing Corporation does not guarantee a thinly traded series.Wrong. The guarantee applies to every listed contract regardless of how actively it trades.
2. B.the bid-ask spread will likely be wide, raising the real cost of getting in and out.Correct. Execution cost is what thin trading imposes, and a round trip can consume much of the hedge value.
3. C.low open interest prevents the option from being exercised before expiration.Wrong. Open interest counts outstanding contracts and has no bearing on exercise rights.
4. D.the exchange will withdraw the series before the hedge reaches maturity.Wrong. A listed series remains available until its expiration once it has been opened for trading.

Why: Open interest measures how many contracts in a series remain outstanding and is a reasonable proxy for how actively it trades. A thin series usually shows a wide gap between the bid and the offer, so the client pays above fair value to enter and receives below it to exit, and that round-trip cost can consume a large part of whatever the hedge was worth. The problem is amplified for a hedger who may need to adjust or unwind at short notice, precisely when markets are disorderly. None of this affects the rights under the contract, which are identical to those in a heavily traded series.

Reviewing an options chain, analyst Naomi Iwasaki sees that a particular contract shows a trading volume of 4,000 for the session and an open interest of 250. What does that combination indicate?

1. A.That 4,250 contracts are currently outstanding, since open interest is added to the session volume.Incorrect. The two figures are never summed. Volume is a daily flow; open interest is the separate stock of contracts still live.
2. B.That 4,000 contracts remain open overnight and 250 were closed during the session.Incorrect and reversed. Open interest of 250 is the number remaining outstanding; the 4,000 figure counts trades executed during the session.
3. C.That most of the day activity was opened and closed within the session rather than held, and the small outstanding position suggests limited liquidity and wider spreads.Correct. Heavy volume against small open interest is the signature of intraday trading, and thin open interest signals a harder exit.
4. D.That the contract must be about to expire, since open interest always exceeds volume in an actively traded series.Incorrect. There is no rule that open interest exceeds volume, and the figures given say nothing about the time remaining to expiration.

Why: Volume and open interest measure different things. VOLUME counts the number of contracts that changed hands during the session and resets to zero at the start of each new session. OPEN INTEREST counts the total number of contracts currently outstanding that have not yet been closed by an offsetting trade, exercised, or allowed to expire, and it carries forward from day to day. Open interest rises only when a new buyer and a new seller open positions against one another, falls when both sides close, and is unchanged when an opening trade meets a closing trade. Heavy volume against a very small open interest therefore means the day activity consisted overwhelmingly of positions being opened and closed within the session rather than accumulated and held, which is the signature of short-term trading. For a practitioner the more useful reading is about LIQUIDITY: low open interest generally accompanies wider bid-ask spreads and greater difficulty exiting a position at a fair price, so a client should be cautious about establishing a large position in a thinly held series.