What Is Open Interest?
Open interest refers to the total outstanding or open contracts in a derivative market at any given time. The quantitative value shows the total number of contracts in the market that have yet to be liquidated. It is frequently observed in conjunction with data from the futures and options markets.
In combination with price and trading volume data, open interest helps investors better understand market sentiment and acts as guidelines for an investment decision. However, its value is sensitive to trading activities, and as a result, at the end of each trading day, the value may increase, decrease or remain unchanged.
Table of contents
- Open interest is explained as the total number of active contracts that have yet to be closed or settled.
- When a new buyer and seller enter into a contract, the OI will increase. As contracts are closed or exercised, the OI will decrease. However, when an old seller and a new buyer enter into a contract, OI remains unchanged.
- Open interest vs. volume indicates that OI isn’t the same as volume. Volume is the total number of contracts traded in a certain period, whereas OI is a running total of the active contracts.
- Traders and investors can look at OI in combination with other indicators like price or trading volume to better understand money flow in the stock market.
Open Interest Explained
Open interest (OI) depicts the number of futures or options contracts open in the market at a specific time while trading in derivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. , such as futuresFuturesFutures refer to derivative contracts or financial agreements between the two parties to buy or sell an asset in a particular quantity at a pre-specified price and date. The underlying asset in question could be a commodity (farm produce and minerals), a stock index, a currency pair, or an index fund. and optionsOptionsOptions are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date., open interest tells us the number of futures or options contracts open in the market at a specific time. It starts with the seller and buyer meeting to initiate a new contract. Then, throughout the trading day, as these contracts are opened, they will tally them based on the trading activities like settling the contracts.
At the end of the trading day, the clearinghouses of financial marketFinancial MarketThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces. consider the number of new contracts open and closed throughout the day. For every new contract opened, an OI gets added, while every contract that closes is subtracted from the total OI. It happens because contracts are counted as open and included in the OI until the other party closes it or the contract expires.
Consider a scenario of a new buyer and new seller meeting, and if both traders open a new position, open interest increases. When an old buyer and old seller close an existing or old position, open interest decreases. If an old buyer sells to one new buyer, the open interest will not vary since the trader transfers his position to a new trader.
The expression below shows the equation that can help traders figure out the total number of outstanding contracts:
OI = Sum of the number of active/open trades – Sum of the number of contracts that have expired/closed
Let us consider the following example to check how to calculate open interest. Suppose, there are three traders A, B, and C, taking the following trades:
|Date||Trading activity||Volume||Open Interest|
|Nov 1||A sells 7 contracts to B||7||7|
|New seller and buyer|
|Nov 2||B sells 2 contracts to C||2||7|
|Old seller and new buyer|
|Nov 3||C sells his 2 contracts to A||2||5|
|Old seller and buyer|
- Nov 1: Seller A and buyer B initiate a new contract. The volume and OI created in the trade is seven.
- Nov 2: B is selling two of his existing contracts to C. In this case, no new contract occurs; instead the existing one is passed to a new buyer, C. Hence the OI remains the same. However, the volume created in the trade is two.
- Nov 3: C is an old seller, and A is an old buyer. When A buys two contracts from C, the closing of two open positions occurs. Both of them closed their existing positions. Hence OI reduces by two. The volume created in the trade is two.
How To Read?
Open interest for options and futures helps traders be aware of the number of outstanding or open contracts at the end of a trading day. It helps traders learn about the market situation at a given point in time. Thus, for an investor to understand how things are working in the market, they must know how to read the data obtained.
For a valid open interest analysis, one must know that:
- A high OI helps traders expect a considerable move in the market soon. Such value encourages more traders to enter the market.
- On the other hand, a low OI makes traders aware that the trading options would be limited, This, as a result, affects the liquidity level of the market and leads to the traders’ exit.
How To Use?
Traders often use OI in combination with price and trade volume daily as a part of their trading strategy to determine price trends and reveal engagement around a particular derivative contractDerivative ContractDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based.. It is always a part of option quotes along with elements like volume, bid, and ask priceAsk PriceThe ask price is the lowest price of the stock at which the prospective seller of the stock is willing to sell the security he holds. In most of the exchanges, the lowest selling prices are quoted for the purpose of the trading. Along with the price, ask quote might stipulate the amount of security which is available for selling at the given stated price.. For instance, on Nasdaq’s financial website, the option chainOption ChainAn option chain is a detailed representation of all available option contracts for an asset. It provides a quick picture of all available put and calls options of the asset with their pricing, volume, open interest details to analyze and take appropriate and immediate actions. for particular security integrates OI data. The following table presents a few commonly accepted guidelines that indicate the overall scenario and help traders determine when to enter or exit a position.
|Price||Open interest||Strength||Market Sentiment|
When price and OI increase, technical analysts infer that the trend continues since the strong bullish sentiment and more traders will open new contracts. When price increases and OI decreases, technical analysts infer that the particular trend is weakening. Decreasing OI is an indicator of market participants closing their position. When the price decreases and the OI value increases, technical analysts infer that the particular trend is weak. When the price and OI value decrease, traders conclude that the specific trend is strengthening and will reverse.
Frequently Asked Questions (FAQs)
OI analysis is an essential aspect while trading in the futures and options market. It indicates the direction of money flow in the market. Following it along with volume and price data can assure a high probability of success and profitability.
Along with other market variables, it is beneficial and vital. It aids in the identification of liquid choices available based on the number of outstanding contracts daily. The OI is quite important in determining how liquid a market is. The more OI there is, the more liquid the market is.
It indicates the total number of outstanding option contracts in the derivatives market. It helps to identify trends and trend reversals. When the price and OI value rise or both decline, it indicates a bullish trend. On the other hand, when price and OI hold an inverse relationship, it shows a bearish trend. Furthermore, checking OI and trading volume signals the current interest.
This has been a guide to what is Open Interest. Here we explain how to read it along with an example, how to use it, and its formula. You can learn more from the following articles –