Open Interest Analysis | How to read it Properly
When trading options, we can sometimes get confused within the wide variety of factors, which have an implication in the behaviour of an option such as "open interest". For this reason, in this post I will analyze the characteristics and functions of this variable within the operation of this type of financial term.
Investing in options; What is open interest?
Open interest is the total number of open or pending options and/or contracts that exist at any given time.
Open interest is commonly associated with the futures and options markets, where the number of existing contracts changes day by day. This differs from the stock market, where a company's outstanding shares remain constant once the share issue is complete.
If a buyer and a seller come together and initiate a new position of a contract, then the open interest will increase. If both a buyer and a seller abandon a single contract position in a transaction, the open interest decreases. If a buyer or seller passes on their current position to a new buyer or seller, then the open interest remains unchanged.
Open interest is sometimes confused with trading volume, but the two terms refer to different measures. On a day when a trader who already owns 10 option contracts sells those 10 option contracts to a new trader entering the market, the transfer of contracts does not create any change in the open interest figure for that particular option. No new options contracts have been added to the market, because one trader is transferring his position to another. However, the sale of all 10 option contracts by the holder of the existing option to an option buyer increases the day's trading volume figure by 10 contracts.
The open interest number only changes when a new buyer and seller enters the market and creates a new contract, or when a buyer and a seller meet and both are closing a position. For example, if one trader has 10 short contracts and another has 10 long contracts, and these traders buy and sell 10 contracts with each other, those contracts are now closed and will be deducted from open interest.
For each seller of a futures or options contract, there must also be a buyer of the contract. A seller and a buyer together create a trade for a certain number of contracts. Therefore, the total open market share for a specific futures or options market is equal to the total number of contracts bought or sold, not the total of both added together.
The importance of open interest
Open interest is a measure of market activity. Little or no open interest means that there is no single opening position, or almost all positions have been closed. High open interest means there are many contracts still open, which means market participants will be keeping a close eye on that market.
Open interest is a measure of the flow of money into a futures or options market. The increase in open interest represents new or additional money entering the market, while the decrease in open interest indicates that the money leaves the market.
Open interest is also used as an indicator of trend strength. Since the increase in open interest represents additional money and interest entering the market, it is generally interpreted as an indication that the current market trend is gaining momentum and is likely to continue. For example, if the trend increases in futures or in the price of the option (or the underlying asset), the increase in open interest tends to favour the continuation of that trend. The same concept applies to downtrends; If the price decreases and the open interest increases, the open interest favours further price falls. Conversely, the decline in open interest reflects declining investor interest and declining momentum, indicating that the current trend will soon run out, leading to a change in trend.
