Whether an option is bought or sold, whether it is a call or a put, when it trades on the exchange, it is considered volume. In short, option volume is the number of contracts traded in a security or an entire market during a specific time frame, usually one trading day. It is simply the amount of options that change hands from sellers to buyers as a measure of activity. If a buyer purchases 100 contracts from a seller or a market maker, then the volume for that period increases by 100 contracts based on that transaction.
Let's look at another example. Say Jim buys 100 calls for XYZ Inc. (XYZ) at the October 30 strike. On the same day, Bill buys 200 calls for the same strike and month. Total volume for XYZ's October 30 strike would then equal 300 contracts (100 calls + 200 calls = 300). This result would hold true regardless of whether the XYZ calls were bought or sold by either Jim or Bill. As you can see, option volume indicates the number of contracts traded at a particular strike for a particular option for a specified time frame.
Option volume is a useful tool for traders, as it can point out where traders are focusing their attention on an intraday basis. For instance, assume that XYZ Inc. reported strong earnings prior to the market open and opened higher when trading began. High call option volume could be the result of such an occurrence, as options traders try to take advantage of the underlying stock's move higher. Vice versa, a negative reaction to the same report could bring about a spike in put option volume. However, if you did not know that XYZ Inc. reported earnings, but saw the heavy option volume changing hands on the stock, you would know that options players were speculating on some event or move in the shares. As such, option volume can be an handy indicator for events (known or unknown) surrounding a particular stock.
Keep in mind, however, that volume is not the same as open interest. Where open interest indicates the actual number of puts or calls in residence at a particular strike or for a particular period of options, volume is merely the number of contracts changing hands. Just because option volume spikes at a particular strike, does not mean that open interest will increase or decrease.
For example, let's return to the 300 calls that were traded on XYZ Inc.'s (XYZ) October 30 strike. Let's say that this particular strike already has open interest of 300 contracts. Without knowing whether or not this option volume was bought to open or sold to close, we do not know if open interest at XYZ's October 30 strike will increase or decrease, or if it will change at all. If the 300 calls were bought to open, then we could see open interest increase to 600 contracts. Meanwhile, if these 300 calls were sold to close, then we could see open interest decline to zero. Furthermore, if these 300 contracts were merely changing ownership, we could see no change in open interest at all.
Combining put and call option volume, we can arrive at another useful indicator in gauging sentiment, the put/call volume ratio. To arrive at this figure, the put volume is divided by call volume. Such ratios are calculated on individual stocks, indices, or the overall market. Near market lows, the put/call ratio will rise as options traders become excessively worried about downside risk and seek to hedge their portfolios or speculate on further downside activity with puts. Near market peaks, interest in calls heats up to form a low put/call ratio. The put/call ratio is thus a contrary indicator when it reaches extreme highs or lows.
Looking at our example on XYZ Inc., we have call volume of 300 contacts at the stock's October 30 strike. Should put volume at the same strike arrive at 100 contracts, the resulting put/call ratio would be 0.33 (100 put contracts / 300 call contracts = 0.33). The closer this ratio moves to 1.0, the more put contracts are being traded relative to calls. As such, a put/call ratio greater than a reading of 1.0 indicates that traders are favoring bearishly oriented puts over calls in greater numbers. Such a development can be seen as a contrarian indicator of excessive pessimism, and can hint at a potential bottom, or rebound, in the underlying stock or index. The inverse can also be seen as a contrarian indicator for a potential top, or roll over, in the underlying stock or index.