Two measurements describe the liquidity and activity of contracts In the options and futures markets:
1. Volume refers to the quantity of contracts traded in a given period
2. Open interest denotes the number of active contracts.
Trading volume measures the number of options or futures contracts being exchanged between buyers and sellers, identifying the level of activity for that contract. For example, assume the volume in call option ABC with a strike price of $55 and an expiration date in three weeks did not trade any contracts on a specified day. Therefore, the trading volume is 0. In the next session, an investor buys 15 call option contracts while a market maker sells 15 call option contracts, lifting trading volume for that session to 15.
Open interest indicates the number of options or futures contracts that are held by traders and investors in active positions. These positions have not been closed out, expired or exercised. Open interest decreases when holders and writers of options (or buyers and sellers of futures) close out their positions. To close out positions, they must take offsetting positions or exercise their options. Open interest increases once again when investors and traders open new long positions or writers/sellers take on new short positions. Open interest also increases when new options or futures contracts are created,
For example, assume the open interest of call option ABC is 0. The next day an investor buys 10 option contracts and another investor sells 10 option contracts. The open interest for this particular call option is now 10.
Options or futures contract trading volume can only increase while open interest can either increase or decrease. While trading volume indicates the number of contracts that have been bought or sold, open interest identifies the number of contracts that are currenltly held.
Price Vs. Open Interest
1. Rising prices in an uptrend while open interest is on the rise indicates that new money is coming into the market (reflecting new buyers). This is considered bullish.
2. Rising prices in an uptrend while open interest is on the decline indicates that short sellers are covering positions. Money is leaving the marketplace; which is a bearish sign.
3. Falling prices in a downtrend while open interest is on the rise indicates that new money is coming into the market on the short side. This scenario is consistent with downtrend continuation and is bearish.
4. Falling prices in a downtrend while open interest is on the decline indicates disgruntled holders forced to liquidate positions and is a bearish sign. However, it can also indicate that a selling climax is near.
5. High open interest while price drops sharply at a potential market top indicates a bearish scenario because holders who bought near the top are now losing money, raising the potential for panic selling.