Before traders buy or sell options, they look at open interest. This metric refers to the number of outstanding options or futures contracts that are yet to be settled. It informs traders whether the money flowing into a contract is rising or falling, and helps them get a sense of its activity.
In this guide, we’ll show you how open interest works and how it can become a part of your options trading strategy.
What Is Open Interest?
Open interest is the number of unexercised or unassigned existing options contracts for a specific security, strike price, type (call or put), and expiration at the end of a trading session.
Importance of Open Interest
Traders use open interest to gauge an asset’s liquidity. Low open interest indicates low liquidity and very few open positions, while high open interest indicates high liquidity and several open positions.
Open interest also reflects the inflow and outflow of money in a futures or options market. Increasing open interest shows new money coming in, while decreasing open interest shows money flowing out.
Traders use open interest alongside trading volume to assess market activity. If open interest is higher than volume, there’s been a high number of closing transactions. If volume is higher than open interest, the option has seen more opening transactions, like buy to open or sell to open.
Open Interest vs. Trading Volume
Open interest and trading volume both help traders understand the demand for options, but there is an important difference.
Open interest is the number of open contracts. A drop in open interest shows that many traders are closing their positions. If a trader holds options contracts and sells them to another trader, it does not change the open interest since the position is not opened or closed.
On the other hand, volume represents the total number of transactions that have taken place. Opening and closing positions both count as transactions. When one trader sells options contracts to another, it adds to the volume.
How Investors Use Open Interest
Traders can discover investing opportunities by identifying how many people are initiating positions. Declining open interest and high volume may entice traders to exit some of their positions because it indicates a weak momentum and low liquidity, which could lead to less favorable pricing.
Open Interest and Trend Strength
Traders monitor trend strength by comparing open interest with volume. When volume outpaces open interest, it shows options swapped hands often throughout the day. A declining open interest can sometimes be a contrary indicator to a recent move, perhaps ending. Some traders may use this to exit positions.
Traders can also compare open interest with the market. If the stock market is dropping while open interest increases, it can tell options traders that bears are in control. Bearish investors eventually retreat. A rising stock market combined with a declining open interest can signal this trend. Because the gains are fueled by bears leaving the market, it is not sustainable. Declining stock prices and open interest can trigger a reversal where the market suddenly becomes bullish.
High Open Interest
High open interest shows traders are opening more positions, whether it’s by shorting options or going long. It doesn’t tell traders whether the trend is bullish or bearish, and they should use additional resources to get the full picture. A high open interest within the context of a rising stock market can demonstrate a bullish trend. More people are entering long options positions that are increasing prices. By combining a high open interest with other variables, it becomes easier to make better predictions.
Example of Open Interest
Suppose Google stock has fallen from $100 to $80 over four weeks. During this time, the open interest on the Google 75-strike put option expiring in one month has increased from 1,500 contracts to 6,000 contracts. This suggests more traders are opening new positions in that put option, likely anticipating further downside.
However, without knowing whether the puts are being bought or sold, open interest alone can’t confirm a bearish bet; it just shows growing interest. If open interest begins to decline while price stabilizes, it might suggest traders are closing out their bearish positions, potentially signaling a reversal.
Combining Open Interest with Other Key Indicators
Open interest isn’t the sole metric that will make or break your options trading strategy, but using it alongside other data can help you make more accurate trades. Fortunately, there are user-friendly options trading platforms that simplify the work and save time.
Questions and Answers
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It depends on which side of the trade you’re on, but rising open interest makes options contracts more liquid, benefiting traders.
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There’s no ideal open interest in options; it depends on other market indicators. The returns you generate from the changes to open interest also depend on the position you have in your portfolio.
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Higher open interest is better if you seek liquidity. It’s important to consider additional context before deciding whether higher or lower open interest is better for your portfolio.
