Open Interest is the third most important indicator after price and volume. It is defined as is the number of contracts outstanding at the end of a day. Open Interest is very important for any Future and Option Trader.
To understand open interest, lets first understand how Futures and Options are traded. Futures and Options are created out of thin air when two traders enter into opposite sides of the agreement. In stocks, where you have a fixed number of shares (outstanding shares), you can use the words “buy” or “sell” when you trade shares of stock. If we take the example of options, because options are created out of thin air, when you trade an option, you are either entering into the contract or getting out of it. So if you are buying a call option to enter (or increase) the position, you need to enter the order as “buy to open.” When it comes time to exit (or reduce) that position, you would enter an order to “sell to close.” You can also enter into an option contract by selling it first. If you sell a call option to enter (or increase) the position, you would enter the order as “sell to open”. When closing (or reducing) the position, the words “buy to close” would be used.
How Open Interest is calculated
Open interest goes up or down based on how many new traders are entering the market and how many old traders are leaving. The total number held by buyers or sold short by sellers on any given day. The open interest number gives you the total number of longs, and the total number of shorts.
For example, if two traders 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. This can be summarized in the following table:
So how do you use open interest as a trader?
For those of you who are familiar with volume, the interpretation of open interest movements along with price are very similar to volume. Just as when price goes up on rising volume, it is a bullish sign; so it is with open interest. In fact, here are the rules for trading with open interest:
With the introduction of intraday data for futures and options in Investar, you can now use the intraday screener to scan all the NSE futures for those futures that are gaining on high open interest in intraday (specifically in 5-min, 15-min, 30-min and 60-min timeframes). This can give an additional confirmation, e.g. if an upward price move is accompanied by high open interest, then that is healthy and indicates a higher chance that the upside move will continue and so on.
Open interest also gives you key information regarding the liquidity of a future or option. If there is no open interest for an option, there is no liquidity for that option. When options have large open interest, it means they have a large number of buyers and sellers, and hence more liquidity and this will increase the odds of getting option orders filled at good prices. So, all other things being equal, the bigger the open interest, the easier it will be to trade that option at a reasonable spread between the bid and ask.
Differences between Open Interest and Volume
Volume for a futures contract is simply the number of contracts that have been traded on a particular day. Volume does not distinguished between how many contracts were opened or closed (long or short). It also does not give a clear picture about how many contracts were opened and are still open in the market, while Open Interest is a cumulative total of all the open contracts at the end of the day. While volume will reset each day, the open interest carries over to the next day.
To summarize, just as volume is a very important indicator in a stock trader’s arsenal, if you are a future or option trader, open interest plays an equally important role as volume for decision-making purposes.