How To Use Open Interest In Trading Options

March 31, 2013
By Vlad Karpel

tradingdeskOpen Interest is the total number of contracts that are open and have not been settled. Open Interest accounts for both futures and options contracts and can allow a trader to see where most of the activity and/or liquidity is for any given instrument.

It is important to understand how open interest can affect the price action of a stock or instrument upon expiration. The strike that has the most open interest can act as a magnet on expiration day. Many times this is due to price manipulation because market makers want the contracts for those strikes with high open interest to expire worthless. We’ll go over a strategy that can be applied around options expiration to take advantage of this valuable tool.

Open Interest Strategy

One strategy that can be applied using open interest around options expiration is a pinning play using a butterfly option spread. Ideally you would like to find a stock a few days ahead of expiration with extremely high open interest at one particular strike. It should be obvious with at least double the amount of open interest than any other strikes (if this strike lands on an even whole number, say $100, it’s even better). This works best on high volume, larger stocks like AAPL, Apple Inc.

When you’ve found a setup, you want to buy a butterfly spread against that strike, where you are selling the strike with high open interest and buying the strikes on either side of your main strike. For example, say you noticed AAPL was trading around $480 and you notice a huge amount of open interest at the $500 strike. You would buy a butterfly spread against that strike which would sell 2 contracts at the $500 strike and buy 1 contract of the $495 strike and 1 contract of the $505 strike (this is the minimum position size, but you can adjust accordingly). Puts or calls doesn’t matter as it works the same either way. What you want, in order to make max profit, is for AAPL in this scenario to close at or within a few pennies of $500 upon Friday’s expiration.

Low Risk High Reward Trade

This isn’t a strategy that has a high win percentage, as the odds of a stock “pinning” at a specific price on expiration is rather small. However it is a very low risk – high reward strategy that can be applied. Typically you would like to get these butterflies for around $0.30-$0.60 per contract so you are only risking $30-$60 per contract. If the stock closes within a few pennies of that strike price, your butterfly spread will be worth $5 for a profit of $500 per contract (minus what your paid). So you can see that while you are risking a minimal amount, you can potentially make 10x your money. Couple that with knowledge that price manipulation can and does happen on expiration along with the knowledge that it is most beneficial for market makers to pin a stock at the strike with the most open interest, makes this a very viable strategy.

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