Open interest options is a complex and very important topic when it comes to trading options. Options traders should pay close attention to the open interest in a particular asset in order to get a better understanding of what is going on between the buyers and sellers of an options contract. Another important indicator to use in options is volume.
Using both of these helps traders feel what the market sentiment is going to be like for the day. This way, an option trader has a better idea of what kind of investment decisions to make next.
What Does Open Interest Mean In Options?
Lets first define what open interest means in options. Open interest is the total amount of unclosed options contracts that hasn’t been settled (closed) for an asset. If an options contract exists then there is a buyer and a seller. This contract is equal to 100 shares of the asset and it is open until a counterparty closes it.
An open contract has both a buyer and a seller to its name. If both the buyer and seller close their position then the open interest decreases by the number of contracts they entered into in the first place. If a buyer or seller decide to pass their position to another person, the open interest does not change. Open interest is the total number of contracts bought or sold, but not both. New contracts are created when a new buyer or seller enters the market. Open interest changes daily and is usually associated with the options and futures markets.
Open interest reflects investor interest but it doesn’t mean their views are correct or profitable. Traders and investors can look at the open interest to get a sense of investor sentiment, and also see where the action is being looked at. If there is a lot of open interest, then this means that the market trend is gaining momentum or will continue, and vice versa.
Open Interest Versus Volume
Volume and open interest are two key indicators that options and futures traders can use to gauge the activity of contracts in their respective markets. A change in open interest and volume is an important activity that is looked at closely by traders but there is a difference between the open interest and volume. Let’s first define the two to get an idea of how they can be used in options trading.
Volume is the number of contracts traded in a period of time while open interest is the number of active contracts. Traders can use a sort of volume open interest indicator to trade. Volume measures the exchange of contracts between buyers and sellers for a particular contract.
If a buyer buys 10 option contracts for ABC at a strike price of $100 and a seller sells 10 options contracts, the trading volume has increased by 10. Traders and investors see high volume as a good indicator that there will be a greater interest for that specific security. Higher volume also means a trader can get in and out of a position quickly.
Open interest measures the number of contracts that are active positions, which means they haven’t been closed, expired, or exercised. Open interest decreases when holders or writers close out their positions and increases when traders buy long or write short positions, as well as when new contracts are created. The difference between open interest and volume is that volume can only increase while open interest can either increase or decrease. Volume measures the contracts that were bought or sold while open interest is the number of contracts currently held.
Change in Open Interest and Volume
A change in open interest and volume indicates different markets in a given time. As a trader, make sure to look at the following open interest and volume correlations to get a better understanding of what is going on in the market.
- Rising prices in an uptrend while open interest is decreasing indicates short sellers are covering their positions. Money is leaving the market which is considered bearish.
- Falling prices in a downtrend while open interest increases indicates that new money is coming into the market on the short side which is considered a downtrend continuation and bearish.
- Open interest numbers flatten following a rise in both price and open interest—this might be a sign of a top in the market.
- An abnormal number of open interest in a bull market is a dangerous sign. When this rising trend reverses, expect a bear trend to follow.
- A breakout from a trading area is stronger if open interest rises during consolidation. Many traders will be caught on the wrong side of the trade when the breakout happens. Price moves out of the trading range and traders are forced to leave their positions. The greater the rise in open interest during a consolidation period, the greater the possibility of a potential move to happen next in the market.
- Rising prices in an uptrend while open interest increases indicates that new money is coming into the market which is considered bullish.
- Falling prices in a downtrend while open interest decreases indicates holders letting go of their losing positions and is bearish. It can also mean the selling climax is near.
- When there is high open interest and the price drops suddenly at a possible market top, then this is bearish since holders who bought near the top are losing money and could panic sell.
Why Do Open Interest and Volume Matter?
Options traders not only have to keep an eye out for the change in price of a particular asset, they also have to look out for the daily volume and open interest in the options market. By understanding all these factors, a trader and investor can make better-informed decisions.
A trader can use daily trading volume to look at the strength of the price movement in the option’s stock. But, this trading volume has to be compared to the average daily volume of a given stock. When there is a significant change in price followed by higher than normal volume, then this indicates a change in sentiment in the market. But, if this increase in price with low volume indicates that there is not much strength in the move. It could even indicate that a price reversal is coming soon.
Options traders should not ignore the open interest number that is given along with bid price, ask price, implied volatility, and volume. Open interest indicates the number of contracts that are currently existing and held. Open interest is not updated during the trading day, unlike volume. There is no way of telling whether the open interest of the options was bought or sold.
Using Open Interest and Volume to Trade
Traders should use open interest with volume to gain some valuable information about what is going on with the contracts. When the volume is higher than the open interest on a trading day, it indicates that trading that option had a high interest that day. Open interest also helps traders understand if there is liquidity for it. When there is a large open interest, there are many buyers and sellers which helps to get orders filled easily. The bid and the ask will also have a reasonable spread in prices.
An example of this is if there is a lot of high open interest for a particular ABC company of around 10,000 then there are a lot of investors looking to trade this market. The bid price of the option is $1.20 and the ask price is $1.25 so it is likely that a trader can buy an option at a mid price between the two. Traders specifically look for contracts that have a tight bid and ask price, as well as high liquidity to get in and out of positions quickly. For investors who want to hold longer, high volume and open interest is also a good indicator for their investment decisions.
When traders use open interest and volume to guide their investment choices, they can understand what other traders are doing during the trading day. These indicators can be used to identify opportunities that would be overlooked if volume and open interest were not being used. Open interest and volume are also important to inform of the liquidity so that a trader can enter and exit a trade at the best price. Traders have to use indicators to have a better understanding of what other traders are doing and feeling on the market.
If you are looking to join a group of like-minded traders interested in options, join the RagingBull webinar to go over what there is to know about options.