Open Interest Meaning Example Future Option Strategy

Open Interest Meaning

In combination with price and trading volume data, open interest helps investors better understand market sentiment and act as guidelines for an investment decision. However, its value is sensitive to trading activities, and as a result, at the end of each trading day, the value may increase, decrease or remain unchanged.

Key Takeaways

Open interest is explained as the total number of active contracts that have yet to be closed or settled.When a new buyer and seller enter into a contract, the OI will increase. As contracts are closed or exercised, the OI will decrease. However, when an old seller and a new buyer enter into a contract, OI remains unchanged.Open interest vs. volume indicates that OI isn’t the same as volume. Volume is the total number of contracts traded in a certain period, whereas OI is a running total of the active contracts.Traders and investors can look at OI in combination with other indicators like price or trading volume to better understand money flow in the stock market.

Explanation of Open Interest in Futures and Options

When it comes to trading in derivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. read more, such as futuresFuturesFutures refer to derivative contracts or financial agreements between the two parties to buy or sell an asset in a particular quantity at a pre-specified price and date. The underlying asset in question could be a commodity (farm produce and minerals), a stock index, a currency pair, or an index fund.read more and optionsOptionsOptions are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date.read more, open interest tells us the number of futures or options contracts open in the market at a specific time. It starts with the seller and buyer meeting to initiate a new contract. Then, throughout the trading day, as these contracts are opened, they will tally them based on the trading activities like settling the contracts.

At the end of the trading day, the financial marketFinancial MarketThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more clearinghouses consider the number of new contracts open and closed throughout the day. For every new contract opened, it will add to the OI. And every contract that was closed will be subtracted from the total OI. It happens because contracts will be counted as open and included in the OI until the other party closes it or the contract expires.

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Consider a scenario of a new buyer and new seller meeting, and if both traders open a new position, open interest increases. When an old buyer and old seller close an existing or old position, open interest decreases. If an old buyer sells to one new buyer, the open interest will not vary since the trader transfers his position to a new trader.

Open Interest Example

Consider three traders A, B, and C.

Nov 1: Seller A and buyer B initiate a new contract. The volume and OI created in the trade is seven.Nov 2: B is selling two of his existing contracts to C. In this case, no new contract occurs; instead the existing one is passed to a new buyer, C. Hence the OI remains the same. However, the volume created in the trade is two.Nov 3: C is an old seller, and A is an old buyer. When A buys two contracts from C, the closing of two open positions occurs. Both of them closed their existing positions. Hence OI reduces by two. The volume created in the trade is two.

Open Interest Trading Strategy

Traders often use OI in combination with price and trade volume daily as a part of their trading strategy to determine price trends and reveal engagement around a particular derivative contractDerivative ContractDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based.read more. It is always a part of option quotes along with elements like volume, bid, and ask priceAsk PriceThe ask price is the lowest price of the stock at which the prospective seller of the stock is willing to sell the security he holds. In most of the exchanges, the lowest selling prices are quoted for the purpose of the trading. Along with the price, ask quote might stipulate the amount of security which is available for selling at the given stated price.read more. For instance, on Nasdaq’s financial website, the option chainOption ChainAn option chain is a detailed representation of all available option contracts for an asset. It provides a quick picture of all available put and calls options of the asset with their pricing, volume, open interest details to analyze and take appropriate and immediate actions.read more for particular security integrates OI data. The following table presents a few commonly accepted guidelines that I can indicate and based on which traders determine when to enter or exit a position.

When price and OI increase, technical analysts infer that the trend continues since the strong bullish sentiment and more traders will open new contracts. When price increases and OI decreases, technical analysts infer that the particular trend is weakening. Decreasing OI is an indicator of market participants closing their position. When price decreases and OI value increases, technical analysts infer that the particular trend is weak. When price and OI value decrease, traders conclude that the specific trend is strengthening and will reverse.