When it comes to trading options and futures there are several important metrics that are important to understand, especially the difference between open interest vs volume. Open interest reflects the total number of contracts for a particular future or option. This means that all of the contracts in existence will be represented by the open interest. The trading volume, on the other hand, represents the volume of traded contracts in a particular timeframe.
Both these metrics should be considered when trying to determine the liquidity, and how wide the bid-ask spread will be for a particular contract.
What is open interest?
Open interest refers to the number of contracts that exist for a specific future or option. This means that all of the contracts in existence on a specific date will be represented by the open interest. Open interest is subject to change, as contracts are created and closed.
Open interest reflects the disparity in views by both those buying and selling the contract. It reflects the interest of market participants to trade a particular contract over another.
Open interest can also be used to assess liquidity. However, in order to determine the liquidity of a certain futures or options contract, you should not rely solely on open interest. This is because it just reflects all the contracts in existence at a determined date.
Trading volume seems to be a much better indicator of liquidity because it reflects how many contracts are being traded daily. It should also be noted that the higher the open interest, the more liquidity should be expected for a particular contract.
What is trading volume?
Trading volume represents the number of futures or options contracts exchanged on a specific date. This is a great indicator of liquidity because it represents how market participants are exchanging a particular contract. It should always be compared with open interest. In order to assess not only liquidity, but you can also determine whether contract underwriters and holders are exiting their positions.
How open interest and trading volume should be used to trade?
Both these metrics are important in order to determine if a certain asset price will move in one direction or the other. An increase in the open interest of a certain contract should be seen as a sign of expected higher volatility. This volatility will then be expressed in higher trading volume, which could make futures and options contracts extremely volatile.
Analyzing liquidity in open interest vs volume
Open interest is often used as a liquidity measure for futures and options. However, this tends to not be the best metric to assess the liquidity of a specific contract. Open interest only represents the total number of contracts that exist.
This does not mean that these contracts will be traded every day. Therefore it should not be used as a standalone metric to determine the particular liquidity of a certain contract. This is because although the open interest for a contract might be high, this does not necessarily mean that the volume traded will also be high.
Trading volume tends to be a much better metric. Because it allows investors and traders to analyze how many contracts are exchanging hands in a particular timeframe.
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