The recent surge in cryptocurrencies has gained widespread attention from traders who love trading options. Crypto options are attractive because they offer investors opportunities to trade large blocks of cryptocurrencies without making hefty financial commitments.
One of the best ways to predict the future movement of crypto options is by analyzing their trading volume and open interest. Any experienced options trader will tell you that these two indicators are the lifeline of options contracts.
The trading volume reflects the number of options contracts traded during the day. It’s a powerful indicator that shows the strength of the price movement in a particular direction.
Similarly, open interest is another dynamic variable that shows the active interest of the trading community. A high open interest indicates that options traders are very interested in holding and trading the contract.
What Is Crypto Options Trading?
Crypto options are a type of derivatives contract that gives the owner the right to buy (call) or sell (put) an underlying crypto asset at an agreed-upon price at a future date. It allows traders to speculate the future price of the underlying asset.
To simplify things, let’s define a crypto option as another way to hold a large number of crypto assets by paying a fraction of the total price of the asset. If you’re confident to predict the future movement of a cryptocurrency within a set time frame, consider trading options contracts. In fact, options are attractive because they allow traders to gain substantial benefits even when risking only a small amount as compared to crypto futures contracts or perpetual swaps.
Before going any further, let’s relate buying and selling an option to buying and selling a home. This will help you to understand the concept of options.
Let’s suppose you want to buy a home that’s selling for $300,000. You’re interested in the investment because you’re sure that the house price will increase at least $50,000 within a month, due to the completion of a major highway nearby. However, you need time to arrange $300,000 through your bank, and it will take approximately 30 days to arrange the cash.
To ensure that the seller of the home doesn’t sell the house to anyone else until you can arrange the payment, you decide to pay a premium of $10,000 to the home seller as insurance for not selling the house.
Let’s say that you were able to arrange the loan within 30 days, and during that time the price of the home rose more than $50,000. In this instance, you’ve only lost the premium of $10,000. On the upside, you’ve gained a significant amount in the process.
In options terminology, the insurance you paid to the home seller is comparable to an option premium. Every time you buy or sell an option, you need to pay a premium. The premium is just like insurance because it allows you to control a large investment while paying a relatively small amount. If the time expires, you only lose the premium.
Crypto options example:
When the same concept applies to crypto options, an option seller will pay a premium to create a call contract on a crypto options exchange with an expiry date to settle the strike price. However, the premiums price varied depending on the time remaining on the contract, implied crypto volatility, and also the interest rates of the underlying assets.
In any case, if a trader wants to buy a call option with an intrinsic value at a strike price lower than the actual value of an underlying asset will have to pay a higher price for the contract before the contract expires.
Now, let’s apply the concept to crypto options. Let’s say 1 BTC is trading at $47,000 on Sept. 15, but trader A predicts the price will be higher by the end of his one-month contract. So, he created an option contract with a strike price of $49,000 for a premium of $0.005. Upon the contract expiry, the BTC is at $50,000, trader A would have made $1,000 in gross profit. However, his net profit will only amount to $765 ($1,000 – $235) after the deduction from his premium.
Types of Options & Value of a Contract
There are two types of options: call options and put options.
- Call option: It is similar to buying shares of stock. It gives the holder of the option the right to buy shares at a specified price until a specified date in the future.
- Put option: It gives the holder of the option the right to sell shares at a specified price up until a set date in the future.
If you’ve traded stock options in the past, it’s important to distinguish between a stock option contract and a crypto option contract. When you buy a stock option, you’re controlling 100 percent of the shares of the stock.
However, the number of underlying assets may be different when trading a crypto option. For instance, one Bitcoin option contract represents the right to buy or sell one Bitcoin. You can also buy 0.1 Bitcoin options contracts.
Why Open Interest and Options Volume is Important
Volume and open interest are the two main variables that indicate the potential movement of an option. If you’re new to trading crypto options, keep a close eye on these two variables because they may be the only thing you need to make a good decision.
Open interest is the number of outstanding contracts that have yet to settle. If you’ve bought a contract and you’re holding onto it, that’s an example of open interest. Likewise, volume is the number of contracts being exchanged on a given day by buyers and sellers. The number of contracts bought and sold is the trading volume.
Volume and open interest are reliable indicators because they reflect the overall sentiment of the crypto market. There are two scenarios when interpreting volume and open interest:
- Scenario 1: Whenever the volume and open interest are high, it means that the price of the contract is likely to move in the direction of the market sentiment. It’s not an overstatement to suggest that high volume and open interest give momentum to the contract, which is necessary to move the price in the right direction.
- Scenario 2: Option contracts that have low volume and low open interest are likely to take longer to reach the desired price.
This doesn’t mean you should ignore contracts that have low volume and open interest. Experienced traders understand that options that are out of the money (OTM) — or that have plenty of time till expiration — usually have low volume and open interest.
Keeping this in mind, a sudden change in trading volume or open interest is usually a sign of movement. If a passive contract suddenly becomes active, it’s usually a sign of future activity.
How Does Open Interest Affect the Buying Interest?
A higher open interest usually attracts traders because it’s seen as a sign of liquidity, and thus potential motion in a certain direction. Theoretically, buyers prefer a contract that has a large open interest because it means they can quickly close their position at a reasonable price when exiting the trade.
Put simply, the higher open interest indicates that there are a lot of traders holding the contract. Therefore, there’s always someone willing to buy or sell a contract at a desirable price.
This also means that there’s usually less difference between the bid and ask prices. Since the asking price is in a desirable range, high open interest will likely encourage traders to buy the contract and vice versa.
Options Volume vs. Open Interest
Traders are often unable to make important decisions because they can’t critically analyze options volume and open interest. While there is a subtle difference between the two, understanding this difference can play a vital role in making your move.
A crypto trading volume is the number of contracts traded in a given period. Whenever someone buys a contract, sells a contract or closes their position, the contract volume increases accordingly.
Options volume always reflects the volume on a particular trading day. Also known as daily volume, it provides information about the number of transactions that have taken place that trading day. Thus, as the day progresses the daily volume increases with each transaction.
At the end of the day, the daily volume resets to zero and starts all over. For this reason, experienced traders seldom look at the daily trading volume. Instead, bi-weekly, weekly and monthly trends in the trading volume are better indicators of price movements.
Open interest is the total number of contracts held by market participants at any given time. The open interest tells you how many contacts are open (not yet closed).
Whenever someone buys a call or put option, it adds to the open interest. When the position is closed and the trader exits the trade, the open interest decreases. An opening or closing transaction will be reflected in the existing number of contracts held by traders.
Unlike the volume, which increases gradually during the day and resets to zero, the open interest does not reset. If this seems confusing, take a look at the following examples.
Options Volume and Open Interest Example
To understand the difference between volume and open interest, let’s suppose that an option contract has zero volume and zero open interest. At this stage, Cynthia decides to buy five contracts from the writers of options contracts.
As Cynthia is the first trader, here’s what the options chain should display that day:
- Volume: 5
- Open Interest: 5
Encouraged by the open interest, another trader, John, buys 10 option contracts the same day. Per the rules, the option chain will reflect the change:
- Volume: 15
- Open Interest: 15
Before the day ends, Cynthia decides to close two of her contracts and hold the remaining three contracts. Under these circumstances, the two additional transactions will add to the volume and decrease the open interest.
- Volume: 17
- Open Interest: 13
Before the day closes, an additional trader, Sam who owned four contracts decided to sell all of them. Notice the change in the two variables:
- Volume: 21
- Open Interest: 17
Since the volume will reset on the next day, the options chain should will look something like this the following day:
- Volume: 0
- Open Interest: 17
If an existing or new trader makes another transaction, that will be reflected in today’s volume. Let’s say that John, who’s holding 10 contracts, closes his entire position. Therefore, the options chart will register the change as shown below:
- Volume: 10
- Open Interest: 7
If nothing happens the rest of that day, the trading volumes at the end of the first day and the second day, respectively, will be:
- First Day Volume: 21
- Second Day Volume: 10
You can easily relate these examples in order to better understand the definitions of volume and open interest. From a trader’s viewpoint, open interest is the number of contracts held by traders at any given time. In contrast, trading volume is defined as the total number of trading transactions that have occurred on a particular day.
Whether to Buy Options with High or Low Open Interest
High open interest is important because it shows signs of liquidity. Higher liquidity generally means that you can close a position whenever you want to at a reasonable price.
Likewise, the spread between the bid and ask prices is also low because there are lots of interested buyers and sellers. Lower spread means that you can enter the market easily without worrying about the high asking price. As a rule of thumb, bid-ask spread within 10% of the asking price is a sign of solid activity.
Because of these benefits, at-the-money options typically have the highest open interest. Traders are generally more interested in an at-the-money (ATM) option because the option’s strike price is very close to the price of the underlying asset. On the other hand, OTM options often see less trading activity because the strike price is farther from the actual price of the underlying asset.
While a high open interest is beneficial in many instances, it doesn’t mean that you shouldn’t buy an option with low open interest. As discussed, most OTM options will have a low open interest.
Therefore, if you intend to hold a crypto option until its expiration date, low open interest doesn’t really matter. Similarly, if you’re sure that the long-term movement of the underlying asset will be in your favor, low open interest need not be a deciding factor in your decision-making process.
Open interest and options trading volume are key indicators used by most options traders to identify trading opportunities. It’s generally believed that an increase in open interest and trading volume precedes a price increase. Therefore, options contracts that have high open interest and high volume are considered a safe bet.
These two indicators are particularly useful for novice crypto traders. If you’re new to crypto options, it’s wise to pick options that show a lot of activity. It’s perhaps the easiest and the safest bet to learn and trade crypto options without taking undue risks. Happy Trading!