Open interest

Open interest (also known as open contracts or open commitments) refers to the total number outstanding of derivative contracts that have not been settled (offset by delivery).[1]

For each buyer of a futures contract there must be a seller. From the time the buyer or seller opens the contract until the counter-party closes it, that contract is considered 'open'.

Use of Open Interest in Technical Analysis

Many technical analysts believe that a knowledge of open interest can prove useful toward the end of major market moves. For some option traders, open interest indicates the intensity of trading in a financial instrument. If open interest increases suddenly, it is likely that new information about the underlying security has been revealed, which may indicate a near-term rise in the underlying security's volatility. However, neither an increase in volatility nor open interest necessarily indicate anything about the direction of future price movements. 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.

Technical analysts view increasing open interest as an indication that new money is flowing into the marketplace. From this assumption, one could conclude that the present trend will continue. Analogously, declining open interest implies that the market is liquidating, and suggests that the prevailing price trend is coming to an end. A common misconception is that open interest is the same thing as the number of option contracts traded. The difference between the two can be explained with a short scenario here;

Further, according to the definition of open interest in this entry, a change in open interest indicates a difference in the number of buyers and sellers of a financial instrument, or at a minimum an increase or decrease in the size of participants' positions. Like volatility, it has no directional component, it is just a tally of unsettled contracts.

For example, if trader X buys 2 futures contracts from trader Y(who is the seller), then open interest rises by 2.

If another trader A buys 2 futures contracts from trader B, then the open interest rises to 4. Now, if trader X unwinds his position and the counter party is either Y or B, then the open interest in the system will reduce by that quantity.

But if X unwinds his position, and the counter party is a new entrant, say C, then the open interest will remain unchanged. This is because while X has squared off his position, Y’s position is still open. The level of outstanding positions in the derivatives segment is one of the parameters widely tracked by the market.

One complication involved when looking at the overall level of open interest in a futures market is the impact of deliveries. In a physically-delivered commodity, when delivery ultimately takes place the contract that has been delivered is no longer included in the overall open interest tally.

The Importance of Open Interest

Open interest provide useful information that should be considered when entering an option position. First, let's look at exactly what open interest represents. Unlike stock trading, in which there is a fixed number of shares to be traded, option trading can involve the creation of a new option contract when a trade is placed. Open interest will tell you the total number of option contracts that are currently open—in other words, contracts that have been traded but not yet liquidated by either an offsetting trade or an exercise or assignment.

For example, say we look at Microsoft and open interest tells us that there have been 81,700 options opened for the March 27.5 call option. You may be wondering if that number refers to options bought or sold. The answer is that you have no way to know for sure how many transactions have taken place but you do know that there are 81,700 options contracts that remain open. Since there is 1 bought position and 1 sold position for each of these contracts, there are 81,700 positions that remain bought to 'open' and 81,700 positions that remain sold to 'open' for the March 27.5 call option. There are always the same number of positions on either side of the open transactions.

So, when an option is traded with one party opening and one party closing, the open interest remains unchanged. If both parties in the transaction are closing positions then the open interest decreases accordingly. If both parties are opening positions then the open interest goes up accordingly.

One way to use open interest is to look at it relative to the volume of contracts traded. When the volume exceeds the existing open interest on a given day, this suggests that trading in that option was exceptionally high that day. Open interest can help you determine whether there is unusually high or low volume for any particular option.

Open interest also gives you key information regarding the liquidity of an option. If there is no open interest for an option, there is no secondary market for that option. When options have large open interest, it means they have a large number of buyers and sellers, and an active secondary market 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.[2]

Benefits of Monitoring Open Interest

By analyzing 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.

Open Interest - A Confirming Indicator

An increase in open interest along with an increase in price is said to confirm an upward trend. Similarly, an increase in open interest along with a decrease in price confirms a downward trend. An increase or decrease in prices while open interest remains flat or declining may indicate a possible trend reversal.

The relationship between the prevailing price trend and open interest can be summarized by the following table:[3][4]

Price Open Interest Interpretation
Rising Rising Market is Strong
Rising Falling Market is weakening
Falling Rising Market is Weak
Falling Falling Market is strengthening

References

  1. ↑ CME Group. "Daily Exchange Volume And Open Interest". CME Group. Retrieved 2015-03-18.
  2. ↑ Investopedia. "Options Trading Volume And Open Interest". Nasdaq.com. Retrieved 2010-09-01.
  3. ↑ "Open Interest". TradingPicks.com. Retrieved 2010-09-01.
  4. ↑ Donna Kline (2001). Fundamentals of the futures market. McGraw-Hill Professional. p. 142,143 of 256. Retrieved 2010-09-01.

External links

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