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Liquidity is important to complete a round-trip in European options, especially for long positions. This week, we discuss the reasons why change in open interest (OI) is a preferred measure of liquidity of an option compared with OI and volumes.
Round-trip trade
Your trading objective is complete only if you close your long positions and take profits. This is referred to as a round-trip. You need liquidity to complete a round-trip, as European options can only be exercised at expiry.
Volumes, OI and change in OI can be useful as measures of liquidity. Consider volumes. With the Nifty Index currently at 19306, the next-week 19300 call has the highest volumes. The issue is that volumes indicate market interest in a contract for a particular day. What if the Nifty Index climbs sharply in the next two days? Volumes could shift to the strike that is closest to the spot price at that time. Your position, now be in-the-money (ITM), may carry lower liquidity. True, you can still close your (small) positions if you are a retail trader. But you may have to settle for a lower price. This is because lower demand for deep ITM options translates into lower time value compared to same-expiry out-of-the-money (OTM) options.
But what about OI? This represents cumulative open contracts accumulated from the end of the day an option contract is introduced by the NSE till the option’s expiry. There is one issue in considering OI as an optimal measure of liquidity. If you are buying a strike today, then it means that the strike is either at-the-money (ATM) or OTM, as these are typically the optimal strikes to take long positions. The short positions on these strikes could have been initiated a while ago and could, thus, carry large gains from time decay. There may be less motivation for the traders to close their short positions. So, large OI does not necessarily mean high liquidity. Of course, this argument may not hold if the shorts were initiated when the strike was deep OTM and the strike is now either ATM or immediate OTM because the underlying has since moved up. The issue is that it is not easy to know how the build-up in OI has happened over time on a strike. It is easier to apply change in OI as a metric for liquidity.
Optional reading
Change in OI indicates how many contracts were added or closed on a given day. So, your long position should typically be on a strike that has the maximum increase in OI. The argument is that traders must come back to the market to close their short position if the underlying moves against them immediately after initiating the position. This is because you are trading options that have 10 days or less for expiry. A dramatic increase (decrease) in an underlying will increase the delta of a call (put) causing losses for the short positions.
The author offers training programmes for individuals to manage their personal investments
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