Selecting The Right Option for Better Trades

In the last three newsletters in this series (first, second, third) we explored five of the eight essential elements you need to consider when purchasing options. In this newsletter we will take a look at the sixth element . . . Open Interest.

Below is a list of the eight essential elements to consider when purchasing options:

1. Option Month - what month should your option expire
2. Strike Price - what is the best choice
3. Delta - what delta should you consider
4. Time Value - how much time value should you pay
5. Bid & Ask - How much should the spread be
6. Open Interest - is open interest important, what is the requirement
7. Money Management - how much to put in one trade
8. Graceful Exits - if the trade does not go the way you hoped

OPEN INTEREST

Open Interest seems like a simple concept but it has power! Bottom line, if the open interest on the contract that you want to trade is low you will probably have a hard time getting filled and it will almost be impossible to get the option on sale by placing an order in the spread.

What is Open Interest

Open interest is the number of open trades on an option contract for a specific strike and month, since the birth of that option. The open interest will not be reduced until a closing trade is executed on that option month and strike price.

Trades that add to the OPEN INTEREST are:

1. BUYS TO OPEN and
2. SELLS TO OPEN

Trades that reduce the OPEN INTEREST are:

1. BUYS TO CLOSE and
2. SELLS TO CLOSE

OPEN INTEREST versus VOLUME:

Open Interest is compiled by adding together opening trades and subtracting closing trades to come up with a daily balance. The daily balance of the open interest is then carried forward to the next day, and that day's opening and closing trades are added and subtracted, keeping a running total.

Volume, on the other hand, adds all opening and closing trades together for a particular day. It does not matter if the trade is an open or a close, it all gets added together. At the start of the next day, the previous days volume number is discarded and the volume computation starts again at zero.

RULES FOR OPEN INTEREST:

I do not like to trade options that have an OPEN INTERST lower than 100 contracts. That is my bare minimum to to enter a trade. Even if I am SELLING TO OPEN a trade, such as writing a covered call, I still want to see the 100 contract minimum. This is because I might decide to BUY TO CLOSE that trade and when I do I don't want to be the only one trading with the market makers. If there is less than 100 contracts in the open interest the market makers tend to get GREEDY and it is hard to get a fill at a decent price.

I actually LOVE to see thousands in the OPEN INTEREST, because the market makers become kind and the BID x ASK spreads end up very small. When there is a large open interest the market makers are also more likely to fill you in the spread and it makes for a nice wholesale entry and exit into and out of a trade.

Bottom line, if your OPEN INTEREST is low, less than 100, skip the trade. If it is over 100 then you are okay. When you have a choice between two options that are over 100 contracts but one is in the thousands or just much larger - I prefer to use the larger one for ease of entry and exit and a better chance of getting a sale price on the option by placing an order in the spread.

NEXT NEWSLETTER… we will cover MONEY MANAGEMENT!

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