What is Open Interest?
Open Interest is the total number of outstanding derivatives contracts. Open Interest tracks the total number of open positions in a specific contract instead of tracking the total volume traded. Open Interest applies to derivatives markets, including options and futures.
Things to keep in mind:
Open Interest is commonly used in the options and futures markets.
When Open Interest increases, money is likely being added to the market, whereas when Open Interest decreases, money is likely exiting the market.
Open Interest reflects the total number of open derivative contracts.
How can traders use Open Interest?
Open Interest provides a precise picture of the market's interest and liquidity in a contract within the options or futures markets. The insight provided by Open Interest enables traders to see whether money flows into or out of contracts. A new contract is created in the market when a new buyer takes a long position and a new seller takes the corresponding short position. As traders create new contracts, Open Interest increases. Open interest is beneficial because it allows you to ready liquidity by identifying active and inactive contracts. Increased liquidity in the market allows orders to fill faster at smaller bid/ask spreads.
Open Interest is a useful tool for interpreting the strength of a price move. Below is an explanation of how Open Interest can be used to read trends:
If the underlying price of a stock increases and the total Open Interest increases, we can interpret the Open Interest increase as strength to confirm the original move upward. The same applies if the stock's underlying price was decreasing; a high Open Interest would confirm the move downward.
If the underlying price of a stock increases and the Open Interest decreases, we can interpret the Open Interest decrease as a weakness in the move upward. The same applies if the stock's underlying price was decreasing; a decreasing Open Interest would indicate weakness in the move downward.
What is an example of Open Interest?
In the example below, we have three different scenarios of Open Interest changing:
John buys 1 option contract, and Bob sells 1 option contract.
Stacy buys 10 options contracts, and Noah sells 10 options contracts.
John sells his 1 option contract, and Noah buys 1 option contract.
Scenario #1: John chooses to purchase a contract. Simultaneously, Bob decides to sell a contract. A single brand-new contract is the result of this trade, increasing Open Interest by one.
Scenario #2: Stacy chooses to purchase ten contracts, Simultaneously, Noah agrees to sell ten contracts. Ten brand-new contracts result from the trade, increasing Open Interest by ten.
Scenario #3: After a few days of trading, John decides to sell the contract that he bought earlier. Simultaneously, Noah is willing to buy one contract. As a result, there is a valid transaction and the closing of one contract, decreasing Open Interest by one.
How is Open Interest different from Volume?
Open Interest is commonly confused with Volume. Open Interest and Volume are indeed two different metrics. Volume is the number of options contracts traded on a given day, whereas Open Interest is the number of open options contracts on a given day. Contrary to Open Interest, the total Volume counts closing positions as well. Additionally, Open Interest is updated only once at the end of the market day, whereas Volume is updated throughout the market day. Volume and Open Interest can both be used to gain insight into the liquidity of an options contract.
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