Reading open interest levels can help pinpoint a contrarian trade
Subscribers to the February edition of Schaeffer's Option Advisor received this educational excerpt earlier today. But because its so helpful in understanding options basics and strategy, we're going to repost it below!
Learn to Trade Options: Stock Prices and ‘Magnetic’ Open Interest
Options trading can be tricky, and anticipating which stocks will move in what direction can seem like witchcraft to those who don't know what to look for. Options players are always on the lookout for clues about where and how to invest, and the best options traders know where to look for data that can help them rake in the wins. One of the more subtle, and perhaps underappreciated, factors that can help a derivatives trader anticipate the movement of an underlying security is its open interest.
What Is Open Interest?
Open interest is the total number of open contracts for a particular option series. Until a contract is bought or sold to close, exercised, or expired, it remains counted as part of an option's "open interest."
It's very common to find major put open interest concentrated at levels either at or below the stock's current price -- i.e., at-the-money (ATM) or out-of-the-money (OOTM) strikes. This is especially true of some of the broader equity-based exchange-traded funds (ETFs) that have gained popularity among stock traders looking for a hedge, such as the SPDR S&P 500 ETF Trust (SPY) and iShares Russell 2000 ETF (IWM).
What Does Open Interest Tell Traders?
Heavy build-up of open interest can occur at important technical levels, can affect the stock's near-term trajectory, and often provides clues into the collective sentiment towards a stock. In general, we consider a "significant" amount of put open interest to be roughly equivalent to 10% of the stock's average daily volume, concentrated at a particular strike level.
From a sentiment perspective, a massive amount of put open interest at a particular price point is indicative of climactic pessimism, which we would expect to coincide with the exhaustion of selling pressure. Once the stock attains this anticipated "bottom," it then takes relatively little buying power for the shares to stage a reversal.
On the technical side, as a stock approaches a price level with a large amount of open put interest, put sellers may engage in hedging action to manage risk exposure. Option sellers may buy shares to hedge their current position or cover their "naked" options, thus boosting the stock's price and keeping their puts in the money.
On the contrary, if the put-heavy strike is out-of-the-money -- perhaps attractive to shareholders seeking an options hedge to protect paper profits -- the put strike can actually work as a "magnet" to draw the price down as expiration nears. This is because the option will become more sensitive as the underlying security declines, and put sellers will be more motivated to hedge their sold puts with an increase of shorting activity. This "delta hedging" further drives down the price, which in turn necessitates more hedging.
Eventually, the fully hedged put strike price could create a support level, assuming there is not another "magnet" to draw prices down even further.
While such put support has really taken center stage, especially in recent years, there is still a flip side to this scenario of options-related support. Strikes at which there is heavy out-of-the-money call open interest potentially represent resistance. Those who sold the calls have a vested interest in seeing the stock remain below the key strike, and may induce resistance by adding selling pressure when the stock approaches this critical level.