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Posts Tagged ‘option basics’

What Option Open Interest Means to the Trader

Option open interest is the number of options contracts open in a specific option series.  Open interest serves as a measure of option liquidity in the underlying option series.  The higher the open interest, the tighter the bid/ask spreads will be so slippage in trades will be lower.  When looking at option series, you want to be sure open interest is at least 5,000 and that the bid/ask spreads are no larger than 20 point apart.

When net buying or selling occurs in the underlying security, the open interest will show this change in the same direction of trader moves.  Increases in call open interest indicate the underlying is advancing up while increases in put open interest indicate more selling pressure.

Here are some rules on how to interpret open interest levels for OTM calls and puts in relation to the stock’s price movement:

  • Growing OI in Calls – confirms strength of stock’s advance
  • Declining OI in Calls – bearish divergence of stock’s advance
  • Flat OI in Calls – slightly bearish as no additional support for stock advance
  • Growing OI in Puts – confirmation of stock’s decline
  • Declining OI in Puts – slightly bullish as no additional support for stock decline
  • Flat OI in Puts – slightly bullish as it is not confirming decline

The growing interest in OTM and ATM options will confirm the stocks continued movement in the same direction.  Basically, this means the traders who have
been right are still buying more options for continuing the same direction.  In comparison, when open interest falls it indicates that traders are leaving the trade so it will likely end the current movement.  Traders are taking their money off the table.

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Option Basics – What is an Option?

An “option” is a standardized contract originated by the Options Clearing Corporation (OCC) that is exchange-listed.  A stock option is a legal right, but not obligation, to buy or sell shares of a specific stock for a fixed time and a fixed price.  The fixed price gives the option holder the right to buy or sell at a fixed price known as a strike price or exercise price.  The fixed time indicates that a option has a limited life for only a specific period of time then expires.
 
There are two types of options:
 

  • Calls – the right, but not the obligation to buy the underlying stock
  • Puts – the right but not the obligation to sell the underlying stock

How to buy & sell Options

Click to enlarge.

The underlying stock are the shares of stock that are subject to a stock option.  The underlying stock can also be an exchange-traded fund, stock index and other tradeable securities that have options.

Each listed call or put option covers 100 shares of the underlying stock.  Stock options expire on the Saturday following the 3rd Friday of each month.  This 3rd Friday is the last day the options can be traded as the market is closed on Saturday.  If the 3rd Friday is a holiday, then the last trading day will be the Thursday before.  Recently, weekly options have been open on a limited number of stocks and ETFs.  These weekly options are opened on each Thursday and expire on Friday of the following week.  This gives the weekly option a time period of 8 days from opening to close.

There are many different calls and puts trading on each security that is optionable.  Each call and put strike price of each expiration month is a separate option series.  To be part of the same series, the options must be of the same type and have the same expiration, strike price and underlying security.  

For investors, option equal income.  I have always like to identify multiple streams of income from my portfolio. For many, they like to diversify using different stocks in different industries. Others like to add additional investments such as bonds and real estate to create diversification. There is nothing wrong with investors looking to create different types of income. In fact, I believe it may be as close to the holy grail as any concept in investing. I use multiple products and strategies to create multiple streams of income. 

I am focused on generating consistent monthly income by selling options for premium using low risk strategies. You can see more investments at my website: getrichinvestments.com

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Option Basics – What Vega Means to the Covered Write

Vega measures the sensitivity of the price of an option to changes in volatility. Vega is the estimate of the change in theoretical value of an option for the 1% increase in implied volatility. A higher volatility means higher option prices while a lower volatility means lower option prices. Vega is the measure of changing volatility on option prices. A higher volatility means an expected higher price swings in the stock.

An increase in volatility will increase the price of options on the stock while a decrease in volatility will cause all options on the stock to decrease. The vega of a long call or put option is always positive while the short calls and puts are negative. At-the-money (ATM) options have the highest vega so they are most sensitive to volatility changes. The further an option goes ITM or OTM, the smaller its vega will be. As volatility decreases for ITM and OTM options, vega is unchanged for ATM options. Vega decreases when time elapses similar to call premium decay. This causes vega to be higher for long dated options than short dated options. Of course, LEAPs have a high vega so an increase in volatility will raise the time value of the option.

For example, a stock that is trading at $35 with a high volatility of .75 with a vega of 30%. The stock option will lose $.30 for every 1% decrease in volatility and gain $.30 for every 1% increase in volatility. If volatility decreases by 20 points, then the stock option will decrease by $6.00. This suggests that you do not want to buy any call or put with a high volatility. Vega can cause option prices to change even if the stock price does not change.

Typically, I do not use vega in covered call trades as I tend to only sell options on stocks below 40% volatility and usually in the current option month. However, vega is important if you use LEAPs as a replacement for stock in a covered call trade.

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