Open Interest in Option Trading: Definition, Example and Importance
The term "open interest" indicates the number of open contracts for a specific future or option Since traders sell and buy contracts throughout the day, this number may fluctuate. This number changes throughout the day as traders buy and sell contracts. It is a trading factor because it indicates a particular market.
Open interest: Definition
When examining an option or futures quote, open interest is often displayed together with the current price (bid, ask, and last) and volume. The volume shows all contracts that were exchanged during the specified time. Another reliable indicator of how actively a market is traded in volume. However, the volume only predicts a little when an option or future is leaning towards selling or buying.
Open Interest: Example
Suppose Billy and John are trading the same contract. Billy sold one contract, and John bought three for a long position. In such a scenario, an increase in the open interest of up to four will be observed. On the other hand, a decrease in open interest would be observed if the traders exit the position. It means that the open interest would fall to one if John sold all his three long position contracts.
Changes to Open Interest
It's vital to understand that open interest does not represent the sum of each transaction by each buyer and seller. Instead, it indicates the total number of contracts. You can also say that open interest is the sum of all buys or all sales, but not both.
A change in open interest would occur if a new trader entered the market. For instance, one trader has ten long contracts, and the other has ten short ones. If both these traders trade these contracts with each other, the contracts will be closed.
The term "open interest" is frequently used to refer to the futures and options markets, where the number of open contracts fluctuates during the day. These marketplaces are not like the stock market. In the stock market, the number of outstanding shares remains constant once the stock issuance is finished. However, these marketplaces are different.
The alleged predictive power of open interest is a frequent myth. It is unable to predict price movement. High or low open interest represents investor interest but does not necessarily imply that their positions will be successful or that their opinions are accurate.
Open Interest vs Trading Volume: How are they different?
Although the terms open interest and trading volume are occasionally used interchangeably, they refer to different metrics. The open interest for a particular option stays the same on the day when one trader sells all his option contracts to a new trader joining the market.
Since traders are moving their position to another, no new option contracts have been introduced to the market. However, selling a particular number of contracts to an option buyer doesn't indicate an increase in the trading volume figure.
The Importance of Open Interest
The open market is an indicator of market activity. A little open interest indicates that there are no or all filled available positions. High open interest suggests numerous unfilled contracts, which signifies the close market monitoring by participants.
A futures or options market's open interest is a gauge of the amount of money entering those markets. While declining open interest implies money leaving the market, increasing open interest shows new or more money entering it.
Options traders place great importance on open interest since it offers vital information about an option's liquidity.
How Open Interest Indicates Trend Strength?
Open interest is also a tool for assessing the strength of a trend. Rising open interest is typically taken as a sign that the current market trend is increasing in popularity or is likely to continue because it implies more capital and interest in a market.
For instance, increased open interest tends to support the sustainability of a trend where the price of the underlying asset, such as a stock, rises. The same idea holds for downward trends. When open interest rises, and the stock price falls, open interest encourages additional price falls.
Many technical analysts think that understanding open interest can reveal important market information. For instance, if open interest slows down after a long-term price trend, either up or down, that could signify that the trend is ending.