Open Interest: Reading the market

Open interest is a concept all option traders need to understand. Although it is always one of the data fields on most option quote displays (also called Option Chain) - along with bid price, ask price, volume and implied volatility - many traders ignore open interest. It is as important as knowing the option's price or current volume.

Unlike spot market trading, in which there is a fixed number of units are to be traded, option trading involves the creation of a new option contract when a trade is placed. Open interest indicates the total number of option contracts that are currently open - in other words, contracts that have been traded but not yet liquidated by either an offsetting trade or an exercise on maturity (call buyers have the right to buy) or assignment (put buyers have the right to sell).

Why is it necessary to understand Open Interest?

Open Interest is a helpful tool in analyzing the strength of a price move. There are four main interpretations of Open Interest

• If price increases and open interest increases, then there is strength behind the price move higher.
• If price decreases and open interest increases, then there is strength behind the price move lower.
• If price increases and open interest decreases, then there is weakness behind the price move higher.
• If price decreases and open interest decreases, then there is weakness behind the price move lower.
• In other words, Open Interests allows us to quickly gauge where the money is flowing.

How does Volume helps track the market?

Volume helps measure how much activity is occurring on a day (intraday). Unlike spot markets, one cannot fully gauge the demand/supply using volumes. If the volume increases it does not necessarily mean that the open interest has increased too.

Open Interest indicates the open positions in the underlying scrip/contract. Open positions reveal what the traders expectation of the future is.

Open Interest quickly tells us where the money is going. If the number rises, that means new (fresh) contracts are being made. In other words, Open Interests allows us to quickly gauge where the money is flowing.

Why knowing the trading volume of the underlying futures is important?

Trading volume gives an important insight into the strength of the current market direction for the option underlying futures asset,

Trading volume is relative and needs to be compared to the average daily volume of the underlying assets or futures. A large percentage change in price accompanied by larger than normal volume is a solid indication of market strength in the direction of the change. But large percentage increases in price accompanied by small trading volumes are less likely to indicate a market direction. In fact, they may indicate that a reversal is likely in the near term.

While simultaneous increasing of open interest and volume, direction of the trend price movements is likely to remain unchanged. However, the decline in volume and open interest is a signal of the end of the current trend.