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What Is Open Interest?
Open interest is the total number of outstanding derivative contracts, such as options or futures that have not been settled for an asset. Open interest keeps track of every open position in a particular contract, rather than tracking the total volume traded in it, which may also included netting or closing positions.
Thus, open interest can provide a more accurate picture of a contract's liquidity and interest, identifying whether money flows into the contract are increasing or decreasing.
Key Takeaways
- Open interest is the total number of open derivative contracts, such as options or futures that have not been settled.
- Open interest equals the total number of bought or sold contracts, not the total of both added together.
- Open interest is commonly associated with the futures and options markets.
- Increasing open interest represents new or additional money coming into the market while decreasing open interest indicates money flowing out of the market.
Open Interest
Understanding Open Interest
Open interest is the number of options or futures contracts that are held by traders and investors in active positions. These positions have been opened, but have not been closed out, expired, or exercised. Open interest decreases when buyers (or holders) and sellers (or writers) of contracts close out more positions than were opened that day.
To close out a position, a trader must take an offsetting position, or exercise their option.
Open interest increases once again when investors and traders open more new long positions or sellers take on new short positions in an amount greater than the number of contracts that were closed that day.
For example, assume that the open interest of the ABC call option is 0. The next day an investor buys 10 options contracts as a new position. Open interest for this particular call option is now 10. The day after, five contracts were closed, 10 were opened, and open interest increased by five to 15.
Technical analysts use open interest, along with other metrics, to gauge the strength of a market trend. Increasing open interest indicates that new traders are entering the market, and may be used to confirm a current market trend. Declining open interest shows that traders are closing their positions, and the current trend may be weakening.
Changes to Open Interest
It's important to note that open interest equals the total number of contracts, not the total of each transaction by every buyer and seller. In other words, open interest is the total of all the buys or all of the sells, not both.
The open interest number only changes when a new buyer and seller enter the market, creating a new contract, or when a buyer and seller meet—thereby closing both positions. For example, if one trader has ten contracts short (sale) and another has ten contracts long (purchase), and these traders then buy and sell ten contracts to each other, those contracts are now closed and will be deducted from open interest.
Open interest is commonly associated with the futures and options markets, where the number of existing contracts changes from day to day. These markets differ from the stock market, where the outstanding shares of a company's stock remain constant once a stock issuance has been completed.
A common misconception of open interest lies in its purported predictive ability. It cannot forecast price action. High or low open interest reflects investor interest, but it does not mean that their views are correct or their positions will be profitable.
Open Interest vs. Trading Volume
Open interest is sometimes confused with trading volume, but the two terms refer to different measures. On a day when one trader who already holds 10 option contracts sells those 10 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 option contracts have been added to the market because one trader is transferring their position to another. However, the sale of the 10 option contracts by an existing option holder to an option buyer does increase the trading volume figure for the day by 10 contracts.
The Importance of Open Interest
Open interest is a measure of market activity. Little or no open interest means there are no opening positions, or nearly all the positions have been closed. High open interest means there are many contracts still open, which means market participants will be watching that market closely.
Open interest is a measure of the flow of money into a futures or options market. Increasing open interest represents new or additional money coming into the market while decreasing open interest indicates money flowing out of the market.
Open interest is particularly important to options traders, as it provides key information regarding the liquidity of an option.
A high open interest indicates that a large number of traders have taken active positions in a derivatives contract. If open interest increases over time, that means that new traders are entering positions, and money is likely entering the market. If open interest declines over time, that is a sign that traders are starting to close their positions.
Open Interest and Trend Strength
Open interest is also used as an indicator of trend strength. Since rising open interest represents additional money and interest coming into a market, it is generally interpreted to be an indication that the existing market trend is gaining momentum or is likely to continue.
For example, if the trend is rising for the price of the underlying asset such as a stock, increasing open interest tends to favor a continuation of that trend. The same concept applies to downtrends. When the stock price is declining, and open interest is increasing, open interest supports further price declines.
Many technical analysts believe that knowledge of open interest can provide useful information about the market. For example, if there is a deceleration in open interest following a sustained move—either up or down—in price, then it might be foreshadowing an end to that trend.
Real-World Example of Open Interest
Below is a table of trading activity in the options market for traders, A, B, C, D, and E. Open interest is calculated following the trading activity for each day.
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- Jan. 1: Open interest increases by one since only one contract is created consisting of a buy and sell.
- Jan. 2: Five new options contracts are created, so open interest increases to six.
- Jan. 3: Open interest declines by one because traders A and D sell one contract to close their positions. As stated earlier, open interest is not the total of both buy and sell trades.
- Jan. 4: Open interest remains at five since there are no new contracts created. Investor E bought five existing contracts from C.
Is Higher Open Interest Better?
High open interest usually indicates higher liquidity for a contract. This generally means there will be less of a difference between what someone wants to sell an option for and what someone else wants to buy it for. This can make it easier to either buy or sell. If open interest is increasing and becoming higher, this signals that the market trends around that option are likely to continue.
Is Open Interest Bearish or Bullish?
Rising open interest usually means that there is new buying happening, which is a bullish trend. However, if open interest grows too high, it can sometimes be a bearish signal that indicates a coming change in market trends.
What Happens When Open Interest Increases?
When open interest increases, this usually means new money is coming into the market for that option. As long as this is happening, the current trend will continue. When open interest decreases, this is usually a sign that the market is liquidating and more investors are leaving. This often means that the current price trend is ending.
The Bottom Line
Open interest is the total number of open derivative contracts that haven't been settled. They haven't been exercised, closed out, or expired. It is associated with the options and futures market, rather than the stock market.
Open interest is equal to the total number of contracts. It is not the total of each transaction by every buyer and seller. This means that open interest is the total of either all sells or all buys, not the total number of both.
When open interest goes up, this represents new money coming into the market and is usually a bullish sign. This usually means that the current market trend for that option will continue. When open interest decreases, this represents money flowing out of the market and means the current trend in price is ending.
