Have you ever glanced at a stock chart, witnessed the price movement, and asked yourself, "I wonder what is really happening behind the curtain?" Price and trading volume tell a story, but just like any good mystery, there is frequently an important clue missing when we try to evaluate (quite frankly) anything related to price movements and trading volume. With respect to derivatives, those wonderful financial instruments such as futures contracts and options contracts, one of the main missing clues is typically Open Interest (OI).
For many, OI (Open Interest) remains a mystery, often overlooked and understated when compared to price and trading volume. However, just because one might overlook OI does not mean you should! If you focus on the positives of using OI, it can enhance your overall understanding of market sentiment, liquidity, and the conviction behind price movements. Let's get into the details and examine how to make sense of this important metric.
Understanding Open Interest in Derivatives
Most simply put, Open Interest is the amount of open (unsettled) contracts, whether monetary (futures) or rights (options), that have yet to be closed or expired. If we think of derivative trading as a conversation with each trade being a new conversation, then OI would simply be the total amount of conversations that are taking place at any one time.
Open Interest (and its chart) has an earned reputation for being confusing, and many traders do not know what it means. This is not to say they are not actively using it as part of their trading preferences; it just means they don't fully understand why or how. This makes Open Interest gradually consistent across the board. Unlike volume, which is the number of contracts that are traded in a period of time (a day), Open Interest (OI) is a cumulative number.
OI represents the total number of contracts for which one party holds a long position (the buyer), and another party holds a short position (the seller), and these open positions are open for an offsetting trade, or until they expire. This metric is solely a picture of the numbers open in the market and during which time frame.
If you are new to the world of financial markets, you might find our comprehensive guide on “Basics of Derivatives” helpful.
How is Open Interest Calculated?
The confusion often lies within the actual calculations of Open Interest. The key rule to remember is that when you have an open contract, there is one buyer (long) and one seller (short). However, Open Interest only counts one side of this pair.
Let's illustrate how OI changes with a few simple scenarios:
When OI increases (New Positions): A new long position is bought by a new buyer, and a new short position is sold by a new seller for the first time; a new contract is created.
Example: Trader A buys 1 futures contract from Trader B, who is selling to open a new short position. Open Interest increases by 1.
When OI decreases (Closing Positions): The existing long position holder sells to the existing short position holder, who is buying to cover, closing both contracts.
Example: Trader A (long) sells their 1 futures contract to Trader B (short, and buying to close). Open Interest decreases by 1 contract.
OI Remains Unchanged (Position Transfers): When an existing position changes hands, but no new contracts are created or closed.
Example: Trader A (long) sells their 1 futures contract to Trader C (new buyer). Trader A's long position is closed, but Trader C's new long position will take its place, along with the continuing short position from Trader B. Open Interest remains the same.
It is essential to recognize that Open Interest is not just the number of trades; rather, it is the net total of current obligations.
Open Interest vs. Trading Volume
This is where a lot of beginners make mistakes. While both are useful inputs for analyzing financial markets, Open Interest and Trading Volume are different concepts:
Trading Volume: The total number of contracts that traded over some time (day). It represents the market activity and turnover that took place in that time frame. If volume is high, there was participation and interest during that time frame.
Open Interest: The total number of open contracts in the market that haven't been settled yet. It represents the obligation of capital and positions. If OI is high, the capital is stuck in those contracts.
Analogy: Think of a popular restaurant.
Volume is like the total number of meals served today (how busy they were).
Open Interest is like the entire week of reservations (how much future business is committed).
Both are relevant. High volume with rising OI indicates a strong trend, while high volume with diminishing OI suggests liquidation or profit-taking.
Importance of Open Interest
So, why put importance on this obscure metric? Because Open Interest is a powerful indicator of:
Market Sentiment & Participation
Rising OI: New money is flowing into the market, which implies more conviction and may indicate that the trend is strengthening. In short, there are more people willing to take on new risks.
Falling OI: Money is flowing out of the market, which indicates profit-taking, liquidation, or no conviction at all. This could indicate a weakening trend or even the possibility of a reversal.
Confirmation of Price Trends
OI is also useful when combined with price action to confirm the validity of a trend:
Price Up, OI Up: Good bullish trend. New money is supporting the rally.
Price Down, OI Up: Good bearish trend. New money (usually, new short sellers) is entering to support the downtrend.
Price Down, OI Down: Weak bearish trend. The sell-off may be due to long unwinding (existing longs selling out) as opposed to new bearish selling.
Liquidity Gauge
Higher OI generally means more participants and active positions in a futures contract or options contract, which brings better liquidity and tighter bid-ask spreads.
Identifying Support and Resistance Levels (Especially in Options)
For options contracts, levels of OI that are exceptionally high at strike prices can indicate significant areas of support and resistance. A large amount of Call OI at a particular strike price can act as a ceiling (resistance) while a large amount of Put OI at a strike could act as a floor (support).
How to Use Open Interest in Stock Trading?
Open Interest is mainly a derivatives metric, but the information will indirectly reflect the stock market, as derivatives get their value from the underlying asset. Here are ways you can use OI with your overall trading plan:
Trend Confirmation and Reversals: As already discussed, combine price action with OI data each day. If a stock's futures or options market has a price trend, and you can see OI is being added as the price goes higher, that confirms the strength of that trend. On the other hand, if a stock's price trend is going higher and OI is dropping, then the stock could be signaling a reversal or an exhaustion of buying pressure.
Understanding "Smart Money" Movements: Large, sudden moves in Open Interest (OI) on certain contracts are often an indicator of institutional activity or what is sometimes referred to as "smart money" action. This isn't definitive, but could be a significant part of the process.
Identifying Key Price Levels: If there are liquid options on the stock(s) you are following, you can use the distribution of OI across strike prices to determine key support and resistance levels where a number of OI contracts exist. This can serve as a guide for determining price level zones that may correspond with the potential buying or selling pressure on the corresponding stocks.
Analyzing Short Interest (via Puts/Calls): Although not technically "Short Interest" per se (as would be reported for stocks) a large increase in Put OI could mean increasing bearish sentiment, or a growing number of participants using Put options as a hedge against a stock's decline, and thus could be providing an additional angle on market sentiment.
Remember that Open Interest can be best utilized as a component of technical analysis in conjunction with price, volume, and chart patterns, and is not meant to be used alone as a crystal ball. It can be a strong piece to help see the market in action and to see trader commitment.
Conclusion
Open Interest is much more than just a number; it is also a reflection of the commitment and participation of traders in the derivatives marketplace. By understanding what it is, how it is calculated, and especially how it is different from trading volume, you will have a considerable advantage in interpreting market sentiment and confirming the strength of market trends.
When you add an OI analysis to your trading toolset, you will get new dimensions of insight, such as liquidity, potential support and resistance levels, and the conviction behind price movement. You can begin to look beyond the price and think more about strategy regarding your decisions. For more in-depth analysis and knowledge of the stock market, financial market, and other related topics, Online NIFM provides courses with certifications. You can enroll now for live and recorded classes.
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