Understanding Open Interest A Beginner’s Guide

The world of trading commonly uses the term “open interest,” not infrequently associated with the futures and options markets. So, what is open interest, and why is it important for traders to understand it? The present paper aims to explain the concept of open interest, highlighting its importance as a market analysis instrument. 

Learning Open Interest
Open Interest Simply put, open interest refers to the total number of outstanding contract options that have not been resolved or squared by an offsetting trade. Specifically, FFTT suggests:


What is Open Interest?

Simply expressed, open interest is the total number of outstanding derivative contracts, such as options or futures, that have yet to be settled.  

These are contracts that have been traded but have not yet been liquidated by an offsetting trade or fulfilled by delivery.

Open interest can best be compared to the number of “open chairs” in a game of musical chairs. Specifically, an “open chair” is an open contract. The players are free to sit in new chairs. During the music trader can pull out of the game by closing the position. The total number of chairs in play at any given time is equal to the number of real open interest. 

Why is Open Interest Important?

If the buyer and the seller sign a new contract, the open interest increases. On the other hand, if the buyer and seller close their contract, the open interest decreases. Thus, open interest should matter for the following reasons.

Open interest shows how liquid and biased the market is. An elevated level of open interest implies there is more activity in a particular agreement, meaning that the market is quite liquid, and trades can be easily made. In addition, adjustments in open interest can provide hints to entry or exit funds from the market. 

Open Interest vs. Trading Volume

One of the most important notes is to not confuse open interest with the amount traded; while open interest indicates the number of contracts outstanding, trading volume reflects that exchanged between counterparties within a specific timeframe. The purchase of contracts between one party and the sale of the same agreements between another do not affect the open interest.

It is critical not to mix open interest and trade volume. Open interest is the number of open contracts, whereas trading volume is the number of contracts exchanged within a certain period. Transferring contracts from one party to another does not alter open interest, although it does boost trading volume1.

Interpreting Open Interest

Here's how to understand changes in open interest:

Increasing Open Interest: New money is entering the market, which might indicate a growing trend.
Decreasing open interest indicates that money is leaving the market, which might indicate a deteriorating trend or a lack of confidence in the present price direction.

Conclusion

Open interest is a key metric in derivatives trading that can help you gauge market activity and sentiment. Understanding open interest allows you to make more accurate decisions and perhaps enhance your trading tactics.

Remember, open interest is only one component of the puzzle. Other elements such as price action and trade volume should always be considered when doing a thorough market study.

I hope this blog post has clarified the concept of open interest for you. Happy trading!