I just started option trading a few weeks ago after having spent a couple of months using a paper trading platform. Although I have done pretty well on a few small, single contract call options, I feel more comfortable using the DITM stock replacement strategy. When I look at what's available for the time horizon I am considering--usually 9-12 months, I find that there is often very small open interest numbers. In some cases, the calls I want may have 0 open interest; others may have 5-10. I'm just wondering if open interest should be a factor when buying calls that don't expire for so long? Thanks for any help with understanding this.
Stock Replacement Strategy
- Thread starter louisjxn
- Start date
Yes! No or low open interest implies there is little or no market. Not a good thing. If you feel you must trade the particular underlying using options, consider looking closer to the money, down to around 70 delta, to see if ample Open Interest exists there, and verify the bid/ask spread is tight enough. If not, you may want to select a different security or strategy. If this is not clear, reply & I or someone else will try again.
I have herd of a rule-of-thumb of the specific Option Volume, being a minimum of 20 times the number of contracts you intend to trade. This seems to be a safe metric. However, I think you may not be able to adhere to that. One thought is you would prefer your exit to be more liquid than your entry, and since you are buying a leap (or close to it), the liquidity "should" improve overtime. Another factor, is if you are very lucky and your trades go in your favor (up), then you may wish to Roll your strikes down, after a sizeable move in the underlying which will allow you to preserve some of your gains as well as re-position your strike to one with greater liquidity. (I like rolling if the strike exceeds 86 delta, back to a 70 delta, which seems to be adequate for liquidity and preserving gains). Also, when you have no volume on a particular strike, but the Open Interest seems adequate, I look at the bid and asked sizes to see if the trade seems viable. Below I show an XLB 73 Delta CALL 135 DTE which has no volume and 157 open interest:
For this, I think it would be OK to trade 1/20th of the Open Interest, since the liquidity will likely improve over time, the Bid/Asked spread is 35 cents, which is not ridiculous, and there are reasonable sized Bid/Asked orders sitting there. I find that slowly increasing my bid from the existing bid results in those large bids moving with my price, and sometimes am surprised at the point I get the fill.
Sorry I do not have well-honed criteria, but expect if you think about what you are doing, you will find (slowly) what your rules should be.
For this, I think it would be OK to trade 1/20th of the Open Interest, since the liquidity will likely improve over time, the Bid/Asked spread is 35 cents, which is not ridiculous, and there are reasonable sized Bid/Asked orders sitting there. I find that slowly increasing my bid from the existing bid results in those large bids moving with my price, and sometimes am surprised at the point I get the fill.
Sorry I do not have well-honed criteria, but expect if you think about what you are doing, you will find (slowly) what your rules should be.
Thanks again, stepandfetchit. Your posts have really helped me to better understand this. I'm trying to learn as much as possible, especially about being able to interpret every aspect of an option chain. OI and Bid/Ask have been one of the more difficult things for me to grasp, though. Since I'm a beginner at options trading, I've just been trading one contract at a time, and usually cheaper ATM (or slightly OTM) options for real-life practice. I don't think I will ever trade more than 10 contracts at a time, even when I am more experienced. Hopefully having just a few contracts will allow me some more leeway in using low OI options.