Open Interest - Meaning, Significance and Advantages

Open Interest is the total number of active options and futures contracts that have not yet been settled against an asset at a given time in the trading arena. It is primarily used as an indicator to identify market positions of securities that have not yet been closed for an unknown reason. 

This page covers information on open interest meaning, how it works and its importance. Also, know the difference between open interest and trading volume. 

What is Open Interest?

It is the number of options and futures contracts that are active for an asset at any particular time in trading. It denotes securities positions in the market that have not yet been closed. To summarise, it is referred to as a measure of liquidity in conjunction with market activity. Like any other security traded in the market, it is subject to market changes.

When new contracts are created or opened, it rise. A rise in the number of them indicates that there are more buyers and sellers for a specific security. It decreases when positions in existing contracts are closed out by buyers (or holders) and sellers. 

How Does an Open Interest Work?

Open Interest is a term commonly used in Options and Futures trading, where the number of open contracts changes on a daily basis. It refers to the total number of contracts currently open but still need to be settled or closed out. In simple terms, every trade has two sides: a buyer and a seller. Whenever an F&O contract is traded, it is considered open until one of the parties closes their position through offsetting. 

Open interest also decreases when buyers and sellers close out more positions than the number of open positions for that day. However, open interest will increase again when investors and traders open more new long positions, or sellers take on new short positions in an amount greater than the number of contracts that were closed that day.

Let’s understand with the help of an open interest example

-Imagine there are three traders: A, B, and C. All three are interested in a futures contract.

Day 1: A buys 3 contracts from B. This increases the open interest by 3 since these are new contracts.

Day 2: C decides to enter the market and sells 5 contracts to A. Even though there's a trade, the open interest only increases by 2 (since 5 new contracts were opened but 3 were closed).

Day 3: B decides to close his position by buying back 2 contracts from A. This reduces the open interest by 2 because these contracts are being settled.

So, by tracking the open interest, you can see how many contracts are actively being traded and haven't been closed out yet. This can be a helpful indicator of market sentiment.

Significance of Open Interest

Investors might make conclusions about the day's market activity by monitoring changes in the open interest at the end of each trading day. Here are some major importance of open interest in stock market:

• Open interest plays a significant role in helping options traders understand the liquidity of an option.
• It is a measure of market activity. It indicates if a market will trend or be range-bound, often known as choppy. 
• An increase in open interest indicates that the number of new positions is increasing. This suggests that the market is being traded actively and is more likely to trend while decreasing open interest indicates money flowing out of the market.
• After a sustained price gain, a levelling off of Open Interest is usually an early indicator of the end of a bull market phase.
• To summarise, this type of indicator can be a significant piece of information when evaluating a possible investment.

Difference Between Open Interest and Trading Volume

Although both open interest and trading volume help us measure liquidity and understand the market activity, they have significant differences. Refer to the table below to know the major difference between open interest and trading volume: