What is Open Interest in Options & How Does Open Interest Work?

Open Interest in options trading refers to the total number of outstanding option contracts that have not been settled or closed. It indicates market activity and liquidity helping traders gauge interest levels in specific strike prices or expiry dates. High open interest suggests strong market participation, while low open interest may indicate weak momentum.

What is Open Interest in Options?

Open interest represents the total number of outstanding options contracts that market participants currently hold. It is not the number of contracts traded in a day but the number of contracts that have not been exercised, closed out or expired.

How Does Open Interest Work?

Open interest increases when new contracts are created and decreases when contracts are closed. It is important to remember that every option trade involves both a buyer and a seller.

• New Contract: Open interest increases by one when a new option contract is initiated.
• Closing an Existing Contract: When a trader who previously bought an option sells it or someone who sold an option buys it back to close their position, open interest decreases by one.

Example: You can think of a 100 new call option contracts for a particular stock are bought. Open interest increases by 100. Later 50 of those contracts are sold to close out positions. Now, open interest is reduced to 50.

Importance of Open Interest

Open Interest is a vital indicator in options trading that reflects the strength of market trends and trader sentiment. It helps identify liquidity, trend confirmation and potential reversals.

• Market Sentiment Gauge: High open interest signals strong participation, indicating bullish or bearish confidence.
• Liquidity Indicator: Higher open interest ensures better trade execution and tighter spreads.
• Trend Confirmation: Rising prices with rising open interest confirm a strong trend.
• Potential Reversals: Falling open interest may signal trend weakening or profit booking.
• Helps in Strategy Planning: Traders use it alongside price and volume to plan entry and exit points effectively.

Open Interest vs Trading Volume

While both open interest and trading volume provide insights into market activity, they represent different aspects:

• Open Interest indicates the total number of outstanding contracts. It is a measure of the current market commitment to a particular option.
• Trading Volume represents the number of contracts traded during a given period. It reflects the level of activity and interest in the option.

Open Interest and Trading Volume are key metrics in options trading but they measure different aspects of market activity.

Benefits of Using Trading Volume Data and Open Interest

Trading volume and open interest provide key insights into market strength and trader activity. Together, they enhance decision-making in options trading.

• Confirms Market Trends
• Identifies Entry and Exit Points
• Measures Market Participation
• Detects Price Breakouts or Reversals
• Improves Risk Management
• Helps Analyse Trader Sentiment
• Supports Strategy Validation

How Do Traders Use Open Interest in Trading Strategies?

Traders analyse Open Interest (OI) to assess market sentiment, spot trends and confirm price movements. Here’s how it’s used in strategies:

1. Confirming Trends
   
   • Rising OI with rising price = bullish trend confirmation.
   • Rising OI with falling price = bearish trend confirmation.
2. Identifying Reversals
   
   • Falling OI with rising/falling price can indicate a weakening trend or potential reversal.
3. Spotting Breakouts
   
   • Sudden spike in OI along with increased volume suggests strong interest and possible breakout.
4. Avoiding False Signals
   
   • Low OI may indicate lack of participation traders often avoid trading in such conditions.
5. Support and Resistance Zones
   
   • Strike prices with highest OI can act as potential support/resistance levels.
6. Tracking Smart Money
   
   • Large OI build-up in specific contracts may signal institutional or “smart money” positioning.

Open Interest helps traders make more informed entries and exits, especially when combined with price action and volume analysis.

Indicators for Analysing Open Interest

Open Interest (OI) alone can be insightful but combining it with other indicators helps traders make better decisions. Key indicators include:

• Price + OI Relationship
  
  • Price up + OI up = Strong bullish trend
  • Price down + OI up = Strong bearish trend
  • Price up/down + OI down = Weakening trend or profit booking
• Volume + OI
  
  • Rising volume with rising OI confirms trend strength.
  • Low volume with high OI may indicate uncertainty.
• Put-Call Ratio (PCR)
  
  • PCR based on OI shows market sentiment.
  • High PCR = bearish bias, Low PCR = bullish bias
• Max Pain Theory
  
  • Identifies the strike price where maximum options buyers lose money used to predict expiry price levels.
• Support and Resistance via OI Buildup
  
  • Strike prices with highest OI in calls = resistance
  • Highest OI in puts = support
• Change in OI
  
  • Sudden spikes in OI can signal new positions and potential volatility.

These indicators, when combined, offer a clearer picture of market psychology and potential price movements.

Conclusion

Traders across the globe consider open interest as a valuable tool for options trading. Options trading might seem complex and open interest is an integral part of it. You can start by understanding its meaning, its significance and how it interacts with other market indicators, traders can make more informed decisions. Whether assessing market sentiment, confirming trends or identifying potential reversals, open interest can provide valuable insights that can enhance your option trading strategies.