[Music] hey everyone and welcome back to mike and his whiteboard my name is mike this is my whiteboard and today we're going to delve into liquidity so there's a few aspects of liquidity that will that we focus on here and that's going to be open interest volume and then a bid ask spread for an option spread so today we're going to talk about open interest and volume and how these numbers impact our trading decisions so with open interest and volume basically they're defined as two different things but they're pretty similar so open interest is essentially
the open contract so any contracts that are just out there open they haven't been assigned they haven't been exercised they haven't been closed so how i like to think of it is basically open contracts that are out there that i can become a part of in some way so volume is essentially tracking the number of contracts that were closed or traded that day so if an option was open and then closed that would count towards volume so there's two different aspects with open interest and volume but they pretty much work together and knowing these numbers
and having a high num a number of open interest and volume is going to help us get liquid markets when we're trading options so let's take a look at our first example here where we're talking about open interest so again open interest is the number of contracts open or outstanding so if matt sells a put to joe then an open interest coin would fall into this bucket of open interest coins so what's interesting is that it doesn't really matter how this transaction happens so matt can sell the put to joe or joe can buy the
put from matt in any case as long as this transaction happens and this contract opens between these two people open interest will increase by one so this is important because when people are opening contracts and closing contracts open interest can actually go up and go down and in some cases it can even stay flat which we'll get into a little bit later but it's important to remember that open interest is essentially the open contracts that are out there and it can go up stay the same or go down depending on the number of transactions that
are happening or the type of transaction that's happening which we'll get into in a little bit here so here's open interest but let's look at volume and see the difference between the two so on the next slide here we'll talk about volume and volume is essentially the number of contracts traded per day so essentially if brad sells two puts to sarah or if sarah buys two puts from brad then there's going to be two ticks for volume going into that volume container so what's interesting with volume is that volume can really only go up unlike
open interest where it can go up go down or stay the same since volume is really only tracking the number of sheer transactions that are completed it can only go up so even if a contract is open and closed it's still going to count as volume for each of those transactions so with stock volume there's a difference here between options and stock so open interest is primarily looked at from an options perspective so it shows you the open contracts that are out there but with volume for option volume it's the number of contracts traded in
a day and for stock volume it's the number of shares per day so when we're looking at liquid underlyings we usually look for shares that are that have traded over a million shares a day so you have your stocks like facebook apple spy which is one of the most liquid underlyings out there you're going to see this pretty much happen every single day so now you know the difference between open interest and volume but what i'd like to do to clarify this even further is walk you through five different steps and we're gonna take examples
and we're gonna show you what happens with these examples when a contract's open closed and see what happens with open interest and volume on the next slide here so in one trading day so this is very important so with volume and open interest we're usually looking at one specific trading day so we're going to look at sarah and she's buying five calls from joe so a call contract if we just review is the right to buy 100 shares at a certain strike price so sarah wants to have the right to buy 500 shares from a
certain strike tr a certain strike price from joe here so what will happen is uh option volume is going to increase by five so there were five contracts here so option volume is going to increase by five and this little black number in the upper right is going to keep a tally of everything that happens from here on out so i just wanted to explain that when we see it in the future so we've got option volume increasing by five and we have open interest increasing by five so sarah bought five calls from joe so
they agreed upon that contract and now this contract is open so we had five contracts that were traded which gives us the five volume and five open contracts which gives us the open interest so now let's look at another example and it's going to be two different people but it's still going to increase the option volume here and will also increase the open interest so matt and laura are two different people and this is a different underlying let's say so matt sells two puts to laura so matt is selling two puts to laura so the
option volume will increase by two which gives us the total of seven for the entire day and open interest is going to increase by two so our total has increased to seven again so actually we're going to pretend that this is the same underlying since we're going to be tallying this up and we want to keep everything universal so we'll be looking at the same underlying from here on out so the next example here we've got joe buying back one call from sarah so originally sarah bought five calls from joe so there's five open contracts
there so joe's buying one back so maybe he's saying you know what maybe i don't want to have the exposure of five naked calls so i'm gonna buy one back and sarah agrees to let me do that so essentially option volume is going to increase by one because that's just another transaction that's taken place so now our option volume has increased to eight and open interest has actually gone down by one so you can see here that open interest goes from seven down to six and that's because originally from the first example sarah had opened
five call contracts from joe so there was five open but now since there is one closed although we have volume increasing now we only have four open contracts which is why this number is decreasing here down to six so that's very important and what's very interesting is that we're never going to really know who we're opening these contracts with and who is closing or opening contracts but this is just a good example to give you a general idea as to how this might happen in the future in case you see maybe open interest up on
a certain period of the day and then a little bit later if it goes down then now you know why so let's look at the fourth example here so matt buys one call from sarah so matt wants to get in on on the call business here so he is making another transaction so our option volume goes from eight to nine and our open interest actually stays flat so in this case since matt is buying one call from sarah so sarah is already short four calls so if matt buys one he's buying one contract to open
but sarah is essentially selling one contract to close so since matt's buying to open and sarah's selling to close there's no additional open interest that's created because she's closing one contract but he's increasing one contract in the open interest market so that's going to be a wash in this case so again since matt's opening one and sarah's closing one there's a wash in open interest which is why it remains at six so if we're looking at all of these from the same underlying perspective in one trading day if we go through this again we've got
option volume of nine and we would have open interest of six so this is basically to point out that regardless of what happens it's very important to know what's open and what's being opened or sold to close and how these numbers are affected and it's pretty rare to see volume and open interest be the same exact number but for each of these what's really important is going to be on our takeaway slide here on the next slide so when we're looking at open interest and volume we essentially want to see something above a thousand that's
going to be ideal for us so when we're talking about just strikes specifically if i'm looking at a strike and i'm looking for maybe a spread or a naked option i want to make sure that either open interest or volume has over a thousand contracts open or a thousand contracts traded that day and that's just going to give me a good indication that there's a fair market for that specific strike because the more options that are traded or the more options that are open and closed that gives me a good idea of people agreeing upon
the bid and ask spread which is going to make that spread narrow and give me a more fair market price and we're going to talk more about bid ask spread tomorrow but that's basically why we want these numbers to be higher and with stock volume if i'm looking at a an underlying to trade in general i want to be looking at a stock volume of over 1 million shares per day and that's just because if i'm looking at a stock volume first i want to make sure that there's a lot of shares in the stock
traded per day maybe i've got shares along with a short call so maybe i'm doing a covered call so i want to make sure that regardless of what strategy i'm using the underlying shares are traded are liquid and that's going to give me a better market price theoretically with the option market so that's not always the case for underlyings like cash sale indexes like spx where you can't actually trade the underlying but it's a good place to start for stock volume so some other takeaways here open interest refers to the number of contracts outstanding so
again open interest i like to think about about it as contracts that are just out there that i can be a part of and these are contracts that are not closed not exercised and not assigned so basically contracts that are just open that i can either become part of by selling to open or buying to open or buying to close selling to close to reduce that number and option volume is simply the total number of contracts traded per day so when we're talking about options we're looking at contracts traded per day when we're talking about
stock we're talking about shares traded per day so it's important to know the difference between the two of those but essentially when we're looking at volume we're just seeing where the action is if you will so normally we will see the most action will generally be around the at the money strikes but sometimes you'll see a lot of action outside in the out of the money or in the money strikes but in general you'll see a lot of liquidity right around the at the money strikes and normally if when we're looking at that it's going
to be pretty relevant to what we're trading so if we're trading something like a debit spread where we're close to at the money strikes then usually that's going to give us a good indication of a high liquidity so this has been part one of liquidity so we've discussed open interest volume tomorrow we're going to talk about bid ask spread and we're going to talk about basically how this affects our option pricing and why it's good to have a narrow bid-ask spread rather than a wide one so thanks so much for tuning in my name is
mike if you have any feedback or questions at all shoot me an email at com or you can tweet us at dotra until tomorrow have a great night hey everyone thanks for watching our video if you liked this video give it a thumbs up or share it with a friend click below to watch more videos subscribe to our channel or go to our website [Music] you
