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Open interest is the sum of active futures and options contracts that are not settled at the end of a trading day. It helps the trader to know the positions that are still open and to know the level of activity in the market. Because of its reflection of participation and the level of liquidity, open interest is often used to analyse trends and the strength of a market, as well as potential market reversals in derivative markets.
Key Takeaways
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Open interest is the total number of active futures or options contracts that have not been settled.
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It helps the trader analyse the liquidity of the markets, the strength of trends, and possible reversals.
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Increasing open interest indicates new participation and movement of trends.
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Falling open interest signals a decline in activity, which suggests weakening momentum or a possible end of the trend.
What is Open Interest?
Open interest is the number of active options and futures contracts for a specific asset during a specific time. It highlights positions in the market that have not been squared off, expired or delivered yet. This makes it a useful measure of how liquid the stock is and how much traders participate in it.
Open interest increases when new contracts are formed, which is an indication that there are more buyers and sellers in the market. It decreases when the traders close out their positions. Like any traded instrument, open interest changes according to the movement of the market, market sentiment, and the flow of new or existing positions.
How Does Open Interest Work?
Open interest is much used in the derivatives market, particularly futures and options trading, when a change in contract activity happens daily. It is the aggregate number of contracts which are then open and not closed or settled. Each transaction involves a buyer and a seller, but open interest is only increased when a brand-new contract is created. When traders offset or close their positions, open interest declines.
Open Interest also goes down when the number of closed positions is greater than the newly opened positions for the day. However, if traders make new long or short trades in larger amounts than those being closed, open interest increases again. This steady increase or decrease helps traders to understand whether money is flowing in or out of the market, which is especially useful when analysing high open interest stocks for trend strength. Higher open interest usually points to reinforcement of trends, while falling open interest could be an indication of exhaustion in trends.
Let's understand this with the help of an open interest example
Imagine three traders, A, B and C, deal in futures contracts.
Day 1: Trader A purchases 4 contracts from B. Since these are new contracts, the open interest will increase by 4.
Day 2: Trader C sells 6 NEW contracts to A. Because 6 new positions were created and none were completely closed, open interest increases by 6.
Day 3: Trader A protects some of his position and sells 3 contracts back to B. Since these contracts are being settled, open interest has declined by 3.
Through this tracking, traders can identify high open interest stocks that show strong market participation and potential trend continuation or reversal. It becomes a useful tool for market sentiment, trend strength, and potential reversals.
How to Calculate Open Interest?
Each trade completed on the exchange has an impact upon the level of open interest for that day.
For example, if both parties to the trade are initiating a new position ( one new buyer and one new seller), open interest will increase by one contract.
If both traders are closing an existing or old position ( one old buyer and one old seller) open interest will decline by one contract.
The third and final possibility is one old trader passing off his position to a new trader ( one old buyer sells to one new buyer). In this case the open interest will not change.
What Happens When Open Interest Increases?
A rise in open interest typically indicates fresh capital entering the options market, supporting the ongoing trend. Conversely, when open interest declines, it suggests market participants are exiting, potentially leading to the conclusion of the prevailing price trend.
Importance of Open Interest
Open interest is a crucial metric in the futures and options markets, reflecting the total number of outstanding contracts. It provides valuable insights into market sentiment, liquidity, and potential price trends.
Rising open interest indicates growing market participation and suggests potential price trends, while declining open interest may signal a market reversal. Traders and analysts use open interest to gauge market dynamics, identify trading opportunities, and manage risk effectively in derivative markets.
Also Read, What are Derivatives here
Using Open Interest for Trading
Traders often use open interest in conjunction with price movements to interpret market dynamics. When prices rise along with increasing open interest, it suggests a bullish trend, indicating new positions are being established. Conversely, falling prices accompanied by rising open interest can signal a bearish trend as more contracts are added. However, divergences between price and open interest can also provide valuable information. For instance, if prices rise while open interest decreases, it may indicate that the current trend is losing momentum.
Here's a simple interpretation table for open interest and price movements:
|
Price Movement |
Open Interest |
Interpretation |
|
Rising |
Increasing |
Bullish sentiment, potential uptrend. |
|
Falling |
Increasing |
Bearish sentiment, potential downtrend. |
|
Rising |
Decreasing |
Bullish trend weakening, possible reversal. |
|
Falling |
Decreasing |
Bearish trend weakening, potential reversal. |
It's important to use open interest along with other fundamental and technical analysis tools to make well-informed trading decisions. Additionally, traders should be aware of market-specific factors and utilise risk management techniques to tackle potential losses.
Working of Open Interest
Open interest estimates the flow of money into or out of a futures or options market. An increase in open interest means new or extra money coming into the market, while a decrease in open interest signifies money flowing out of the market. It is essential to options traders as it offers insights into the liquidity of an option.
Benefits of monitoring open interest
By monitoring the changes in the open interest figures at the end of each trading day, some conclusions about the day’s activity can be drawn.
Increasing open interest means that new money is flowing into the marketplace. The result will be that the present trend ( up, down or sideways) will continue.
Declining open interest means that the market is liquidating and implies that the prevailing price trend is coming to an end. A knowledge of open interest can prove useful toward the end of major market moves.
A leveling off of open interest following a sustained price advance is often an early warning of the end to an uptrending or bull market.
Is Higher Open Interest Better?
High open interest often signifies increased contract liquidity. This enhances the ease of trading, as there's less discrepancy between what sellers demand and what buyers are willing to pay. Additionally, a rising open interest suggests the prevailing market trends associated with that option are likely to continue.
Is Open Interest Bearish or Bullish?
An increase in open interest typically indicates new buying activity, reflecting a bullish sentiment. However, extremely high open interest levels can sometimes serve as a bearish signal, hinting at a coming shift in market trends.
Difference Between Open Interest and Trading Volume
Although both open interest and trading volume can help traders to understand the participation in the markets and help to assess liquidity, they are very different aspects of the market. The table below summarises the main differences between the two concepts so that you can more easily interpret market behaviour and identify potential trends.
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Key Elements |
Open Interest |
Trading Volume |
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Meaning |
Reflects the aggregate number of outstanding and open futures or options contracts of a certain asset at any given time. |
Indicates the number of contracts traded at a given session or period of time. |
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What it Measures |
Counts contracts which are still open and not squared off, expired or exercised. |
Tracks the number of contracts that were purchased or sold over a specified period of time. |
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Focuses On |
Stock open interest Shows the continued presence in the market, revealing the interest of traders and the strength of a trend. |
Reflects short-term activity, indicates immediate buying or selling pressure |
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Data Update Frequency |
Updated once at the end of every trading day. |
Updated continuously during the market hours. |
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Interpretation |
Rising stock open interest indicates rising positions and stronger trends whereas, falling OI implies winding down. |
High volume means there is high trading and there is volatility; and low volume means there is less participation. |
Open Interest and Volume
Open interest and volume are the two important concepts in the futures market. Traders look at both to predict trends.
Let’s discuss them one by one. Though both OI and volume are quite similar, which often confuses new traders, they are not the same.
OI represents the number of open contracts in the futures market, in possession of individual buyers and sellers.
Now for the futures market, for every contract sold, there should be a buyer. So, the number of total contracts transacted in the day remains balanced. Volume refers to the total number of contracts executed during the day. So, if one contract is sold and bought, the volume goes up by one (pls note: the volume adds up by 1 and not 2 because only one contract passed between the buyer and seller).
At the beginning of the day, the volume is set to zero. Hence, you get a clear picture of the number of contracts exchanged hands during the trading hours. Open interest is not as discreet as volume. The value of open interest may remain unchanged or change depending on the number of traders entering or exiting the trade.
Let’s discuss further with the help of an example. Consider there are three traders in the market, A, B, and C.
On day one, seller B sells 8 futures contracts, and Buyer A buys all eight. So, after day one, both volume and open interest stood at eight.
Next day, A sells five contracts and C buys five contracts. At the end of the second day, volume changes to five (number of contracts changed hands); but open interest remains unchanged at eight because no new contract was created in the market.
It is important to note that volume changes daily, but the open interest may remain unchanged for days. Open interest will remain the same unless new contracts are initiated, or the old ones are settled or executed.
Conclusion
Hope you have now got a fair idea of: what is open interest? Now here is a word of caution. If you see that there is a lot of open position along with significant price change, refrain from entering the market. It is an indication that the market is in the grip of an unexplained over-enthusiasm. When it happens, even a small trigger is enough to cause panic among traders. If it happens then, everything will come crashing down.