Have you ever wondered how many people have the same option contract as you? There’s actually a number for it: open interest. Some traders look at it before buying and selling options. Combining open interest with other data points can help options traders make more informed decisions. This guide will help you understand open interest and its applications.
What Is Open Interest (OI)?
Open interest is the number of existing options contracts for a specific security, strike price, type (call or put) and expiration. These contracts have not yet been exercised or assigned.
Why OI Matters
Assume you find an option contract with an open interest of 10,000. What does that mean? How do options traders use this information to make more informed decisions? Open interest doesn’t let you know whether traders are bearish or bullish. Opening a long or short position will increase open interest while closing a position will do the opposite.
Some traders use open interest with trading volume to gauge activity. If open interest exceeds trading volume, the option experienced a quiet day or more people closed their positions. If volume exceeds open interest, the option experienced more opening transactions, such as buy to open or sell to open.
Open interest also says a lot about an option’s liquidity. A lower open interest implies less liquidity, and you may not have the flexibility of entering and exiting positions at the more favorable midpoint.
Open Interest vs. Trading Volume
Open interest and trading volume both help traders understand the demand for options. However, they have some nuances. Open interest measures the number of open contracts, whether traders are bullish or bearish. A declining open interest means more people are closing their options positions.
Volume represents the number of transactions that took place. Opening and closing positions both count as transactions. For open interest, a newly opened position would cancel out a recently closed position. High trading volume and low open interest can indicate low liquidity.
How Investors Use Open Interest
Knowing how many people are initiating positions can help traders discover opportunities. Declining open interest and high volume may entice traders to exit some of their positions because lower liquidity will result in less favorable costs associated with closing positions.
OI and Trend Strength
Open interest allows traders to monitor trend strength and gauge market sentiment. You can assess the strength of a trend by comparing open interest with volume. When volume outpaces open interest, it can indicate 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 experiencing losses 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.
Monitoring open interest, underlying assets and trading volume can help you detect trends, but getting the timing right is the main challenge. Using these data points does not guarantee success, but these insights may put you in a better position to generate positive returns.
High Open Interest
High open interest indicates traders are opening more positions, whether it’s by shorting options or going long. This data point does not tell traders whether the trend is bullish or bearish, and you should use additional resources for your options trading strategy. But if you combine a high open interest with other variables, it becomes easier to make better predictions. A high open interest combined with a decreasing stock price can be that way because people are opening short calls and long puts. A high open interest under the context of a rising stock market can demonstrate a bullish trend. More people are entering long options positions that are increasing prices.
Example of Open Interest
Assume a stock traded at $100 per share four weeks ago and now trades at $80 per share. The stock has fallen 20%, but options traders don’t stop with this truth. These traders want to know why the decrease occurred and which group of traders is controlling the stock price. A trader checks the open interest and discovers it has increased in correlation with the stock price’s decrease.
The rising open interest demonstrates bearishness. Since the stock has fallen 20%, it’s reasonable to assume that more people are opening long puts and short calls instead of opening long calls and short puts. A trader can choose to join the crowd or wait for open interest growth to decelerate. As open interest growth decreases and flips to negative, it can indicate a reversal.
Combining Open Interest with Other Key Indicators
Open interest isn’t the secret metric that will make or break your options trading strategy. But using this data point alongside other information can help you make more accurate trades. It’s good to stay on top of these numbers and monitor stocks, but you don’t have to do all of that alone. Traders can use an options trading platform that simplifies the work and saves them time.
Frequently Asked Questions
Is open interest good or bad for options?
A higher open interest makes options contracts more liquid, but good or bad depends on which side of the trade you are on.
What is a good open interest in options?
The returns you will get from changes to open interest depend on the positions you have in your portfolio and how open interest correlates with other market indicators.
Is higher or lower open interest better?
Higher open interest is better if you want more liquidity. It’s important to consider additional context before deciding whether higher or lower open interest is better for your portfolio.
About Marc Guberti
Marc Guberti is an investing writer passionate about helping people learn more about money management, investing and finance. He has more than 10 years of writing experience focused on finance and digital marketing. His work has been published in U.S. News & World Report, USA Today, InvestorPlace and other publications.