An extremely critical part of option trading has to do with stock option open interest and liquidity, as it applies to knowing exactly how to avoid buying stock options contracts which are illiquid.

 

Every single contract for a stock option is quoted including contract name, bid, last price, ask, volume and open interest. The open interest part represents how many open contracts are still floating in the air for a specific stock option. The open interest in options trading should never be confused with volume, which represents instead the number of transactions which have taken place on a particular options trading contract.

 

When an option trader buys a call option, such as a June45Call which is represented by a symbol like QQQDR, then the open interest for QQQDR has increased by 1. When that options trader decides to sell the call option contract, or exercises their call option contract in order to close a position, the interest for QQQDR actually decreases by one. It really is that simple.

 

Many people misunderstand the fact that liquidity of stock option contracts is not represented by open interest. The best measure for liquidity in traditional stock trading is by the stock's volume, which shows how quickly each order is getting filled at the price that the trader is interested in. When it comes to options trading, however, volume is not the best measure for liquidity because many option contracts can be very liquid even when their volume is extremely low. The next unique number that many options traders are turning to is the open interest, which serves as an indication of liquidity for them, but this is not any more accurate. Every option contract begins with a 0 for open interest when it is first launched, and open interest is built up as the options contract is purchased by many other options traders. So 0 in open interest obviously cannot mean that an options contract is completely illiquid. Otherwise, how would options traders build their portfolios up by using these 0 open interest options contracts?

 

When it comes to options trading, the best measure for the liquidity of a stock option is based on how quickly the market makers trade with you when another corresponding option trader is absent. When stock options contracts are first launched with a 0 for open interest, if an options trader buys the stock option they are actually buying them directly from the market makers. These market makers will narrow down the bid-ask spread if they are confidant that the stock option will sell quickly. On the other hand, if they are not confidant about being able to turn a quick profit on a particular stock option contract, they may compensate for the amount of risk by asking for a much more spread-out bid-ask spread. The bid-ask spread offers a great indication for how liquid a stock option is. The bid-ask spread is the difference between the bid price and the ask price, and most trading veterans consider a wide spread to be 15 percent or more.