Open interest is the total number of outstanding derivative contracts for an asset—such as options or futures—that have not been settled. Unlike trading volume, which counts the total number of trades, open interest keeps track of the number of open positions that remain after trading hours on any given day.
Key Insights
- Defining Open Interest: Open interest refers to the total number of open derivative contracts such as options or futures that haven’t been settled.
- Markets Included: It is commonly associated with options and futures markets, as opposed to the stock market.
- Significance: Increasing open interest indicates new or additional money coming into the market, while decreasing open interest signals money exiting the market.
- Roles of Traders: Understanding open interest requires a clear comprehension of buying and selling mechanics to open and close positions.
Understanding Open Interest
Open interest is most often associated with the futures and options markets, where the number of open contracts changes daily. Open interest is the number of options or futures contracts held by traders in active positions. These positions have been opened but not 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.
Specifically, open interest increases when investors and traders open more new long positions or sellers take on new short positions in amounts greater than the number of contracts that were closed that day.
Scenario Example
Consider an example where the open interest of the ABC call option is initially 0. If a trader buys 10 ABC options contracts as a new position the next day, the open interest for this contract is now 10. The day after, if five ABC contracts were closed and 10 new ones were opened, open interest would increase by five to 15.
Note: However, it should be emphasized that high or low open interest reflects only trader interest and sentiments and does not necessarily predict price movements.
Open Interest vs. Trading Volume
Open interest and trading volume are frequently confused, but the two terms refer to different measures. Imagine a trader holding 10 options contracts and selling them to another trader entering the market. This transaction does not alter open interest, as positions were simply transferred rather than created or closed. However, trading volume increases by 10 due to this activity.
Why Open Interest Matters
Open interest serves as a measure of market activity and sentiment:
- Indicator of Market Health: Little or no open interest means nearly all positions have been closed or none are opened. Conversely, high open interest signals that many open positions exist, suggesting high market activity and investor interests.
- Liquidity Insight: High open interest tends to indicate higher liquidity, enabling easier purchase and sale opportunities and rapid market entry and exit.
- Money Flow: Increasing open interest suggests new or additional capital entering the market, whereas declining open interest indicates funds are exiting.
Real-World Example of Open Interest
Here is how trading activities among traders A, B, C, D, and E translate to open interest calculation over a few days:
Date | Activity | Open Interest
----------------------------------------------------
Jan 1 | Trader A buys 1 option from Trader B | 1
Jan 2 | Trader C buys 5 options from Trader D | 6
Jan 3 | Trader A sells 1 option to Trader D | 5
Jan 4 | Trader E buys 5 options; C&sells 5 | 5
FAQs on Open Interest
Is Higher Open Interest Better?: High open interest generally means greater liquidity for the contract, facilitating easier market navigation and transactions.
Is Open Interest Bearish or Bullish?: Rising open interest indicates new buying and is typically seen as bullish. However, exceptionally high interest might signal impending market corrections.
What Happens When Open Interest Increases?: When open interest rises, it usually implies fresh capital entering the market, suggesting the current trend will persist. Conversely, declining open interest often points to market liquidation and an approaching end to the trend.
Final Thoughts
Understanding open interest provides valuable insights into market activity and trader sentiment. While it may not predict price movements directly, monitoring open interest can help traders make informed decisions and better understand money flow dynamics in options and futures markets.
Related Terms: Trading Volume, Market Trends, Liquidity, Options, Futures, Open Position.
References
- CME Group. “Open Interest”.
