Kevin Cook

August 6, 2024 5 mins read Knowledge hub 513 times

What is OI in Options?

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Open interest is the total number of outstanding contracts in a futures or options market. It tells us how many contracts are currently “open” or active, meaning they haven’t been closed or settled yet.

How does it work?

So, let us understand open interest in options trading practically with an example.

Day 1:

• Trader X buys 5 contracts, Trader Y sells 5 contracts.
• Open interest becomes 5 because there are 5 active contracts.

Day 2:

• Trader Z buys 10 new contracts.
• Open interest increases to 15 (5 from Day 1 + 10 new ones).

Day 3:

• Trader W sells 7 new contracts.
• Open interest grows to 22 (15 from Day 2 + 7 new ones).

Day 4:

• No new trades, so open interest stays at 22.

Key points to understand:

1. Open interest increases when new contracts are created.
2. It doesn’t matter if someone buys or sells – if it’s a new contract, it adds to open interest.
3. Open interest doesn’t change when existing contracts are traded between parties.
4. Open interest only decreases when contracts are closed or settled.

Think of open interest like the number of active players in a game. When new players join, the number goes up. When players finish and leave, it goes down. If players just trade positions, the total number stays the same.

This helps traders understand the liquidity and activity in a market, which can be useful for making trading decisions.

Few More Terminologies in Open Interest:

1. Outstanding Contracts:

• Open interest is the count of active contracts in the market.
• This number helps us understand how popular or active a particular market is.

2. Two Sides to a Trade:

• Every trade needs two people: a buyer and a seller.
• The buyer is called “long” (they hope the price goes up).
• The seller is called “short” (they hope the price goes down).
• When a new buyer and seller agree on a trade, open interest goes up by one.

3. Stays Open Until Offset:

• A contract stays “open” until someone closes it.
• Closing happens when a trader does the opposite of their original trade.
• For example:
  * If you bought a contract, you close it by selling.
  * If you sell a contract, you close it by buying.
• When a contract is closed, it reduces the open interest.

What is the difference between Open Interest and Trading Volume?

Open interest and trading volume are two different ways to measure market activity, but they tell us different things. It shows us the total number of active contracts or “bets” that haven’t been closed yet.

This number doesn’t change much from day to day, as it only changes when new players join or when players finish their game and leave. It gives us an idea of how many long-term participants are in the market.

Trading volume, on the other hand, tells us how many trades are happening right now, showing how busy and active the market is at this moment.

This number can change a lot throughout the day. High trading volume usually means there’s a lot of excitement or important news in the market, while low volume might mean things are quiet.

Together, these two measures help traders understand both the long-term interest in a market and its current activity level.

Benefits of Open Interest:

1. Market sentiment indicators:

This data helps traders gauge overall market sentiment and make more informed decisions.

2. Liquidity assessment tool:

Higher volumes generally indicate better liquidity, resulting in tighter bid-ask spreads and lower transaction costs.

This information is valuable for traders seeking to enter or exit positions efficiently, especially in less popular markets.

3. Trend confirmation:

By analyzing open interest alongside price movements, traders can validate the strength of market trends. For instance, rising prices accompanied by increasing open interest may confirm a robust bullish trend.

This combination of indicators helps traders distinguish between sustainable trends and potential false breakouts.

4. Contrarian signals:

Extreme levels of open interest can sometimes indicate market turning points.

Savvy traders may use this data as a contrarian indicator, looking for potential reversals when open interest reaches unusually high levels.

This approach can help identify overbought or oversold conditions in the market.