What is Open Interest
Open interest is the total number of open or outstanding options and/or futures contracts that exist at a given time.
Open interest is commonly associated with the futures and options markets, where the number of existing contracts changes from day to day. This differs from the stock market, where the outstanding shares of a company's stock remain constant once a stock issue is completed.
If a buyer and seller come together and initiate a new position of one contract, then open interest will increase by once contract. If a buyer and seller both exit a one contract position on a trade, then open interest decreases by one contract. If a buyer or seller passes off their current position to a new buyer or seller, then open interest remains unchanged.
Breaking Down Open Interest
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 option 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 the existing option holder to an option buyer does increase the trading volume figure for the day by 10 contracts.
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 and they are both closing a position. For example, if one trader has 10 contracts short and another has 10 contracts long, and these traders then buy and sell 10 contracts to each other, those contracts are now closed and will be deducted from open interest.
For every seller of a futures or option contract, there must also be a buyer of the contract. One seller and one buyer together create a trade for a certain number of contracts. Therefore, the total open interest in the market for a specified futures or option market equals the total number of bought or sold contracts, not the total of both added together.
The Importance of Open Interest
Open interest is a measure of market activity. Little or no open interest means there is no one 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 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 and/or is likely to continue. For example, if the trend is up in the futures or option price (or the underlying asset), increasing open interest tends to favor a continuation of a that trend. The same concept applies to downtrends; if the price is declining and open interest is increasing, open interest favors further price declines.
Conversely, decreasing open interest reflects declining interest on the part of investors and waning momentum, indicating that the existing trend may soon be exhausted, leading to a trend change.