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. The total open interest does not count, and total every buy and sell contract. Instead, open interest provides a more accurate picture of the options trading activity, and whether money flows into the futures and options market are increasing or decreasing.
Open Interest Explained
To understand open interest, we must first explore how options and futures contracts are created. If an options contract exists, it must have had a buyer. For every buyer, there must be a seller since you cannot buy something that is not available for sale.
The relationship between the buyer and seller creates one contract, and a single contract equates to 100 shares of the underlying asset. The contract is considered "open" until the counterparty closes it. Adding up the open contracts, where there are a buyer and seller for each, results in the open interest.
If a buyer and seller come together and initiate a new position of one contract, then open interest will increase by one contract. Should a buyer and seller both exit a one contract position on a trade, then open interest decreases by one contract. However, if a buyer or seller passes off their current position to a new buyer or seller, then open interest remains unchanged.
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 is the total number of outstanding 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 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 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.
- 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.