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.

What happens when OI increases?

When open interest (OI) increases, it usually indicates the entry of new money into the market for any particular instrument like the options contract. It may indicate higher trading activity and interest among investors, potentially signaling a bullish trend. This could also signal heightened belief in the potential of the asset in question. 

An increase in OI may come with more contracts being opened, a continuation of the trend (for the asset price), and also a confirmation of the trend strength/bullish market activity. It could suggest stronger buying pressure as well. However, increasing OI during any price decrease may indicate a bearish trend or possible short build-up. This happens when investors sell the asset expecting a price drop. Higher OI usually equates to improved market liquidity, making it easier to exit or enter positions. If the increase in OI comes with a spike in trading volumes, it may indicate higher market volatility as well.

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.

Is Higher OI Better?

A higher OI (open interest) indicates new money entering the market and vice versa. Hence, higher OI reveals that there is more liquidity for the options contract. This makes it easier for you to enter or exit your positions at fair market prices. At the same time, higher OI may also indicate a continuation of the trend due to new money coming into the market. It could thus be interpreted as a positive sign. 

Is OI Bullish or Bearish?

OI is not intrinsically bearish or bullish by itself. However, the way you interpret it depends largely on the price movements. Here are some key pointers in this regard. 

• A higher OI with rising prices indicates new buying activity and a bullish trend. 
• A higher OI with falling prices signals new selling activity entering the market. This could possibly signal a bearish trend. 
• A declining OI with rising prices may indicate short sellers covering positions. The rally may be weakening as a result. 
• A falling OI with falling prices means that traders are exiting their long positions with the downtrend about to be exhausted. 

However, it is worth noting that OI only reflects past trading activity without predicting future price movements. You should analyze OI in combination with price actions and other indicators to confirm trends. 

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: