Open Interest Simplified - The most simplified write up on open interest and how it works.
Open Interest is a term you will see a lot in futures and options trading, but you may be confused as to what it is and how it works. Let's fix that!
OI (Open Interest) is the amount of outstanding contracts that have not yet been settled. Simply put, these contracts are still "Open". Open Interest provides insight into how much money has moved in or out of a specific contract. When Open Interest increases, it means that new or additional money is moving into the contract. When Open Interest decreases, it means that money is moving out of the contract.
Open Interest is associated with Options and Futures markets because the number of existing contracts can change from day to day. Whereas, in the stock market, the quantity of shares of a company remain constant once a stock issuance is completed.
Open Interest is often used to see where investor interest lies as well as to determine the level of liquidity in a contract. When there is a high Open Interest, it indicates that investors believe this position would be profitable. However, it is important to remember that while there may be a lot of investor interest, it does not mean that they will be correct or that their position will be profitable. High Open Interest can also help to determine if you will be able to easily enter or exit a position.
Open Interest Vs. Volume Open Interest is unlike Volume, because it only updates 1x per day to reflect the total open contracts after all of the transactions that took place on the previous trading day. The open interest is posted by the OCC before the markets open on each trading day. Unlike Volume, Open Interest does NOT reflect the total quantity of contracts transacted. Instead, the open interest value is representing the total increase or decrease in open positions of a specific options contract and tracking how many contracts are currently being held. Open interest changes based on NEW contracts being created or existing contracts being closed.
When both the buyer and seller are using Opening orders (Buy to Open & Sell to Open), the Open Interest will increase. When both the buyer and seller are using Closing orders (Buy to Close & Sell to Close), the Open Interest will decrease. When one side of the trade is an Opening order and the other side is a Closing order, the Open Interest will remain the same.
The examples below will help to illustrate how open interest works. If you keep an eye on who is holding the contracts and how many they hold, it should start to make sense.
- Henry Sells 5 contracts to Mary with a “Sell to Open” order and Mary bought those 5 contracts from Henry with a “Buy to Open” order. - Henry’s Position is now -5 Contracts. Henry will need to buy 5 contracts to close his position. - Mary’s Position is now +5 Contracts. - Because these were both “Opening” positions (Buy to Open AND Sell to Open), the Open Interest has been increased by 5 Contracts because there are 5 new contracts that were introduced to the market. - The volume in this scenario would also increase by 5 because there were 5 contracts traded.
Later that day, Mary decides that she wants to “SELL to CLOSE” the contracts that she purchased from Henry. However, it is Tom who “BUYS to OPEN” the contracts from Mary.
- Mary Sells 5 contracts to Tom with a “Sell to Close” order and Tom bought those contacts from Mary with a “Buy to Open” order. - Mary’s Position is now 0 contracts because she sold the contracts that she previously purchased. - Tom’s Position is now +5 contracts. - Henry still has -5 contracts from selling Mary the contracts that she then sold to Tom.
Important notes: - The Open Interest would remain unchanged at 5 because there were no new contracts created. - The already existing contracts simply traded hands from Mary to Tom. - This would increase the Volume by another 5 contracts because there were still 5 contracts being traded. - However, because these transactions weren’t increasing or decreasing the amount of contracts that were currently open, the Open Interest would remain unchanged at 5.
Later that day, Tom decides that he wants to “SELL to CLOSE” the contracts that he purchased from Mary. However, it is Henry who “BUYS to CLOSE” the contracts from Tom.
- Tom Sells 5 contracts to Henry with a “Sell to Close” order and Henry bought those contacts from Tom with a “Buy to Close” order. - Tom's Position is now 0 contracts because he sold the contracts he previously purchased. - Henry's Position is now also 0 contracts because he bought back the contracts to close his -5 position and brought his position to 0. - All of the outstanding contracts have now been closed which would reduce the Open Interest to 0.
The above examples are extremely simplified, but should help to get an understanding of how Open Interest works.
