What is option open interest?
Many people find it very complex to learn options trading. Learning to trade options is like an engine, it has many working parts that combine to create something wonderful. From Greeks to spreads and open interest! Option open interest can be used to describe the outstanding contracts in any derivative market that have not yet been settled for that financial asset. Either futures or options. The following dives into the open interest of options.
Option open interest vs Volume?
Option open interest should not be confused for volume. Volume is the actual contract completion and traded. Instead think of the open interest as the activity in the options market. Whether its decreasing or increasing the inflow into the options market.
Break down of option open interest
An options contract is two-sided, a buy side and a sell side. Why is that? Because in order to have a contract buyer, you need a seller. The two together create the completion of an option contract. Think of it this way, if you are a buyer of an asset, and there are no sellers. You cannot possible buy anything.
Options contracts are denoted in 100 shares denominations of the underlying. If you buy one Apple options contract, you could have access to 100 shares of Apple if you chose to. When the buyer of the options contract decides to buy a contract. They open the position and the contract is now labeled “open”. It is open until the buyer decides to close the position.
How does open interest change?
When a buyer and seller of an options contract come together to initiate a position, the open interest of that underlying asset increases by one contract. If they both exit the position, then the open interest decreases by one.
The open interest change is equal to the number of contracts being open rather than the transaction of each buyer and seller individually. It takes a buyer and a seller to create opening interest. The means the open interest is equal to either all the buyers or all the sellers. Rather than the combination of the two.
Options contracts can be either puts or calls to the barebone of the contracts. You can buy either puts or calls. So, the open interest can be the total of puts and calls. Or you can break it down by puts or calls. In the image below you will see the open interest of both puts and calls on Tesla. Notice it doesn’t differentiate between sellers and buyers of contracts. New contracts create open interest changes.
The image below splits the calls and puts on the S&P 500 index options. You can see where there is calls interest and where there is put interest. Which could mean that the investors and traders that hold these positions think that the price may lean more towards the 2400 price level and more. Since there is a lot of open interest on that end of the spectrum.
Why is open interest important?
Why do investors and traders follow open interest? It does not define where price will be! People often hold the misconception that high open interest at a certain strike price means that the price of the underlying will get to that level by a certain expiry. It just means that a lot of contracts think that price will get there, not necessarily being correct.
Why do we watch option open interest so carefully? Because it identifies the market activity. When you see open interest fall for certain strike prices on the underlying asset there are very little to no open positions for that level. Based on that expiry investors and traders do not expect price to get to those levels into the expiration.
When there is high option open interest, that means there are a lot of market participants who will be more active around those prices. The increase of open interest means that money flows into the market, creating more movement. Investors and traders usually use the open interest increasing as a momentum strength indicator. If open interest begins to increase as a stock is going up, we can expect the momentum to continue. The opposite holds true as well.
Conclusion
The option open interest should be considered greatly. Especially at strike prices that have large open interest levels. Traders and investors should monitor the change in open interest as well to get the market edge. Open interest should not be confused with the volume of the underlying.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.
