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.
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).
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.
