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It is safe to say that most novice traders in the world are not trading options properly. If we know this, then all we have to do is find the area where most traders are making mistakes and then take the opposite position.
We will then have a high probability for success in our trades. Open interest is a statistic unique to options and futures trading. Open interest is the total number of contracts that are currently in existence and have not been offset by closing trades. This is different than volume which is the number of contracts traded for the day.
If you were to buy an option to open a position and the person who sold you the option is also opening a new position, volume would increase by one and open interest would increase by one.
If you then sold your option to someone else who did not have a position, then volume would increase but the open interest would not change as you transferred your interest to someone else. Open interest would have decreased if you had sold your option to someone who had already sold an option and was buying to close their position.
Since both of you are closing positions, the option contract is not needed anymore and open interest goes down even though the transaction increases the volume reported. Understanding open interest can seem confusing at first, but our instructors at Online Trading Academy do an incredible job at making difficult concepts easy to understand in the classroom. Open interest is important to stock traders and investors as well as option traders. Open interest shows us where traders are putting their money.
Remember that the novice traders are the ones who usually buy options. We can use the knowledge that sellers tend to make money to predict potential price movement for stocks just before the expiration of the stock options. There is a concept in the markets called option pain. When a seller of an option sees the price of the stock move to where they would lose money, they are feeling pain.
By looking at where the open interest of a stock or ETF is, we can make assumptions on the price levels where there would be a lot of pain. Where there is a large amount of open interest, there is also a large probability that the price will not close there by expiration.
This is because if it does, then the sellers of those options would stand to lose a lot of money. In an effort to profit from large option or futures positions, institutional traders will often buy or sell the underlying stock in an effort to push prices to a point where the close will benefit them. This means that the price will often close on options expiration day just above or below the price where the greatest open interest lies and the least amount of pain would be felt.
There is a term for this action, pinning. These traders attempt to pin the price of the stock or ETF to profit from a derivative position. Pinning is illegal in most exchanges in the world and traders who participate in this high volume trading in an effort to manipulate prices could face penalties. The problem is in catching the culprit and the SEC punishing them. But does it really work? That is where the largest open interest happened to be.
Since prices opened above this range in the morning, traders should have been looking for opportunities to short the ETF until it settled into the range suggested by the open interest. So, what can a retail trader do about this pinning? Recognize that it does happen and either stay out of the market or trade the momentum.
Trading this can be very risky as you need to be quick in your decision to enter and exit when the momentum is slowing, not reversing. It is not for everyone, but if you are prepared you may be able to profit from this pinning that occurs in the markets every expiration day. Watching the potential pinning activity in the week before option expiration and also the open interest on the weekly options can also assist those traders looking to make profits on short-term swing trades as well. Trades should only be entered based on supply and demand zones.
The open interest information provided here is only a decision support tool. To learn how to identify the zones accurately and efficiently, visit your local Online Trading Academy office today. Disclaimer This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever.
Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.