Trending Future and Options

What is Open Interest?

Open interest refers to the total number of outstanding options and futures contracts that are being held by market participants at a particular point in time. This is the total number of contracts that have not been exercised, expired, or settled and thus remain open to be either offset by an opposing position or exercised at the expiration date. Open interest is viewed as one of the key factors in derivatives trading. Unlike the trading volume, representing the number of contracts traded in any one period, open interest yields a sense of the total number of outstanding positions in that market.

If new contracts are being created, open interest increases, which means new money is coming into the market. Conversely, when old positions are being closed out, open interest decreases. In order to understand the sentiment in the market, this measure is important. Increasing open interest has many times been interpreted as new traders coming into the market, and decreasing open interest might be because traders are closing out their positions, which could signal a change in the market.

Importance of Open Interest

One critical role of open interest in financial markets is that it's a leading indicator of market sentiment. For example, growing open interest might indicate that traders are bullish about the future direction of prices, while decreasing open interest may suggest bearishness or a lack of commitment to ongoing trends. This insight will enable traders to determine whether to initiate or liquidate positions according to prevailing market conditions.

On the other hand, open interest shows a picture of market liquidity. High levels of open interest translate to a strong market with plenty of participants where one is normally able to enter and exit positions with less disruption of the price, meaning less slippage and better trade prices.

Changes in open interest can be interpreted as an indicator of price volatility. In fact, open interest often rises when prices rise, indicating confirmation of an uptrend, and if prices rise but open interest falls, then it signals a probable trend reversal or weakened momentum. It, therefore, goes without saying that monitoring open interest is incomparable in making better trading decisions.

How to Calculate Open Interest?

Calculating open interest is straightforward and can be done using one of two primary methods. The first method involves determining the total number of outstanding contracts by subtracting the number of closed contracts from the total number of contracts traded during a specific period. The formula is:

Open Interest = Total Number of Outstanding Contracts - Contracts Closed

Alternatively, open interest can also be calculated by summing the total number of long positions and short positions in the market:

Open Interest = Total Number of Open Long Positions + Total Number of Open Short Positions

For example, if there are 500 options contracts at the beginning of a trading day and 150 new contracts are opened while 50 contracts are closed during that day, the calculation would be:

Open Interest = (500 + 150 - 50) = 600

Example of Open Interest

To illustrate how open interest works in practice, consider a scenario involving three traders: A, B, and C.

• Day 1: Trader A buys 3 futures contracts from Trader B. This transaction increases open interest by 3 since these are new contracts being created.
• Day 2: Trader C sells 5 contracts to Trader A. In this case, even though there are transactions involving existing contracts between A and C, only 2 new contracts contribute to an increase in open interest (5 opened minus 3 closed).
• Day 3: Trader B decides to close his position by buying back 2 contracts from Trader A. This action decreases open interest by 2 because these contracts are being settled.

By tracking these transactions over several days, one can observe how open interest fluctuates based on market activity. For instance:

• Start:OI = 0
• After Day 1:OI = 3
• After Day 2:OI = 5
• After Day 3:OI = 3

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