Open Interest is the total number of outstanding contracts that are held by market participants at the end of the day.
It can also be defined as the total number of futures contracts or option contracts that have not yet been exercised (squared off), expired, or fulfilled by delivery.
Open interest applies primarily to the futures market. Open interest, or the total number of open contracts on a security, is often used to confirm trends and trend reversals for futures and options contracts.
Open interest measures the flow of money into the futures market. For each seller of a futures contract there must be a buyer of that contract. Thus a seller and a buyer combine to create only one contract.
Therefore, to determine the total open interest for any given market we need only to know the totals from one side or the other, buyers or sellers, not the sum of both.
The open interest position that is reported each day represents the increase or decrease in the number of contracts for that day, and it is shown as a positive or negative number.
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.
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.
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.
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.