UNDERSTANDING :-OPEN INTEREST IN STOCK MARKETS :-This article is sourced from Investopedia and used in this non commercial blog for the educational purposes of commerce students

Open Interest: Definition, How It Works, and Example-

By AKHILESH GANTI

 

Updated June 30, 2023

Reviewed by 

GORDON SCOTT

Fact checked by 

KATRINA MUNICHIELLO

What Is Open Interest?

Open interest is the total number of outstanding derivative contracts for an asset—such as options or futures—that have not been settled. Open interest keeps track of every open position in a particular contract rather than tracking the total volume traded.

Thus, open interest can provide a more accurate picture of a contract's liquidity and interest, identifying whether money flows into the contract are increasing or decreasing.

KEY TAKEAWAYS

• Open interest is the total number of open derivative contracts, such as options or futures, that have not been settled.
• Open interest is commonly associated with the futures and options markets.
• Increasing open interest represents new or additional money coming into the market, while decreasing open interest indicates money flowing out of the market.
• To comprehend open interest, you should understand that traders can buy and sell to open and close positions.
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• Understanding Open Interest

  Open interest is most often associated with the futures and options markets, where the number of open contracts changes daily. Open interest is the number of options or futures contracts held by traders in active positions. These positions have been opened, but have not been closed out, expired, or exercised.

  Open interest decreases when buyers (or holders) and sellers (or writers) of contracts close out more positions than were opened that day.

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   To close out a position, a trader must take an offsetting position or exercise their option.

• Open interest increases once again when investors and traders open more new long positions or sellers take on new short positions in an amount greater than the number of contracts that were closed that day.

  Here's a simple scenario—assume that the open interest of the ABC call option is 0. The next day a trader buys 10 ABC options contracts as a new position. Open interest for this particular call option is now 10. The day after, five ABC contracts were closed, and 10 were opened. This means that open interest increased by five to 15.

  A common misconception about open interest lies in its ability to make predictions. New traders might be led to believe that it can forecast price action, but it cannot. High or low open interest only reflects trader interest and sentiments.

  Open Interest vs. Trading Volume

  Open interest is sometimes confused with trading volume, but the two terms refer to different measures. For example, imagine one trader holds 10 option contracts and sells them to a new trader entering the market. The transfer of these contracts does not create any change in the open interest because positions were transferred, not closed or opened.

  Trading volume, on the other hand, increased by 10 because of the transferral.

  The Importance of Open Interest

  Open interest is a measure of market activity. Little or no open interest means there are no opening positions, or that nearly all the positions have been closed. High open interest means there are many contracts still open, which means market participants will be watching that market closely.

  Open interest measures money flow into or out of a futures or options market. Increasing open interest represents new or additional money coming into the market, while decreasing open interest indicates money flowing out of the market.

  Open interest is significant to options traders as it provides key information regarding the liquidity of an option.

   

  High open interest creates opportunities to buy and sell. This liquidity helps traders move into and out of positions quickly. If liquidity is low (low open interest), traders are less able to get in and out of the market.

  Real-World Example of Open Interest

  Below is a table of trading activity in the options market for traders A, B, C, D, and E. Open interest is calculated following the trading activity for each day. The key to understanding how this works is whether the trader bought or sold to open or close positions.

  

  Image by Sabrina Jiang © Investopedia 2020

  • Jan. 1: Trader A buys one option to open a position from Trader B, increasing open interest by one.
  • Jan. 2: Trader C buys five options to open a position from D, which increases open interest to six.
  • Jan. 3: Trader A sells one option to D to close a position, decreasing open interest by one.
  • Jan. 4: Trader E bought five options from C to open positions, who sold the five purchased from D to close positions.

  Is Higher Open Interest Better?

  High open interest usually indicates higher liquidity for a contract. This generally means there will be less difference between how much a trader wants for an option and how much another will pay. This can make it easier to buy and sell. If open interest is increasing and becoming higher, this signals that the market trends around that option are likely to continue.

  Is Open Interest Bearish or Bullish?

  Rising open interest usually means that there is new buying happening, which is a bullish trend. However, if open interest grows too high, it can sometimes be a bearish signal that indicates a coming change in market trends.

  What Happens When Open Interest Increases?

  When open interest increases, it usually means new money is coming into the market for that option. As long as this is happening, the current trend will continue. When open interest decreases, it is usually a sign that the market is liquidating and more investors are leaving. This often means that the current price trend is ending.

  The Bottom Line

  Open interest is the total number of open derivative contracts that haven't been settled. They haven't been exercised, closed out, or expired. This measurement is associated with the options and futures market rather than the stock market. Open interest is equal to the total number of open contracts, not the sum of all transactions between buyers and sellers.

  When open interest goes up, it represents new money coming into the market. When open interest decreases, it means money is flowing out of the market. Open interest is not generally viewed as an indicator of trends or price action