In trading, open interest is the number of open futures or options contracts for a particular market. Open interest is an indicator of the strength of the market, showing whether cash is flowing into or out of a particular contract.
Below we delve into how open interest in trading works and how to interpret this critical indicator used to evaluate futures and options contracts.
Definition and Example of Open Interest in Trading
Open interest indicates how many contracts of a particular future or option are open on the market at the moment. This number changes throughout the day as traders buy and sell contracts. Open interest is an important indicator for traders to watch since it can show whether a particular market is trending higher or lower.
Open Interest Defined
Open interest is typically shown along with the current price (bid, ask, and last) and volume when viewing an option or futures quote. The volume shows the total number of contracts traded for the period. Volume is also a strong indicator to show how actively a market is traded. However, it doesn't say as much about whether a future or option is trending toward buying or selling.
As open interest increases, it's often a sign that a trend is rising. Conversely, as open interest decreases, it's often a sign the trend is beginning to wane. The larger the changes in open interest, the more significant the indicator of a trend's direction.
Open Interest Example
If Dave and Suzy are trading the same options contract, and Dave buys three contracts for a long position, open interest would equal three. If Suzy sells one contract, open interest will increase to four. Open interest would decline when the traders exit their positions. In other words, if Dave sold his three long contracts, open interest would fall to one. Regardless of whether their opening trades are long or short, they increase open interest, and open interest declines when they exit their trades. Below is a more detailed explanation of how open interest is calculated.
How Open Interest Works
Open interest is calculated by adding all of the contracts that are associated with opening trades. Then, subtract all of the contracts that are associated with closing trades. For instance, suppose three traders (trader A, trader B, and trader C) are all trading the ES futures market. Their trades might affect the open interest in the following way:
- Trader A enters a long trade by buying one contract.
Open interest increases to 1.
- Trader B enters a long trade by buying four contracts.
Open interest increases to 5.
- Trader A exits their trade by selling one contract.
Open interest decreases to 4.
- Trader C enters a short trade by selling four contracts.
Open interest increases to 8.
Open interest becomes more complicated when you consider that each of the traders is buying or selling from someone else who is selling or buying. Sometimes both parties will be opening trades and increasing open interest, while other times, one party will be closing a trade and the other opening (no effect on open interest). Both parties also could be closing trades (decreasing open interest).
Open interest is not the same as volume. With volume, both entries and exits cause the volume to increase. With open interest, entries cause open interest to increase; exits cause open interest to decrease.
What Open Interest Means for Individual Investors
Open interest is often used as a confirming signal for the current price movement. But on its own, it does not provide much information about price movement. It shows how many contracts are currently in open positions, but it doesn't tell who is long or short.
Measure of Strength or Weakness
Increasing open interest shows that there is strength behind the current price trend because the number of contracts in play is increasing. In other words, activity is increasing, and there's excitement about the move. Decreasing open interest shows that there could be a weakening of the current price trend. Traders are closing out their positions more rapidly than new traders are opening them.
Reversals and Range-Bound Markets
Increasing open interest along with an increasing price indicates that the upward price movement could continue. However, decreasing open interest along with an increasing price shows that the upward price movement may be about to reverse.
Open interest is also used to determine whether a market is likely to be trending or range-bound (choppy). Increasing open interest shows that the rate of new positions is increasing, which indicates that the market is being actively traded and is more likely to trend.
Decreasing open interest shows that the rate of new positions is decreasing, which indicates that the market may experience less active trading and is more likely to be range-bound.
A Word of Caution
Little open interest in an option or futures contract can also mean there isn't an active market for it. Volume also provides this information. However, even if there is a lot of open interest, it doesn't necessarily mean a futures or options contract will do a lot of volume on a particular day. Since open interest reflects open positions, those positions could remain open with little volume, but eventually, those traders want to close their positions.
- Open interest shows how many contracts of a particular future or option are still open on the market.
- Unlike volume, which just shows total contract movement for the day, open interest can indicate what direction a contract is trending.
- Increasing open interest is often viewed as a confirming signal for the current trend since more traders' positions are getting involved.
- A decline in open interest during a trend may indicate a reversal or choppier price period.