The absolute number of unresolved derivative contracts for an asset, such as options or futures, is known as open interest. It gives a more realistic picture of the options trading activity and shows whether or not capital is flowing more or less into the futures and options markets.
Open interest will rise by one contract if a buyer and a seller team up and start a new position of one contract. If both a buyer and a seller cut their positions in a trade by one contract, open interest falls by one contract. Open interest, however, does not change if a buyer or a seller transfers their current position to another buyer or seller.
Open Interest – An Explanation
We must first examine the creation of options and futures contracts to comprehend open interest. An options contract must have had a buyer if it exists. Since you cannot buy something that is not for sale, there must be a seller for every customer.
One contract is made possible by the relationship between the buyer and seller, and it is equal to the 100 shares of the underlying asset. Until the counterparty ends the contract, it is still considered "open". The open interest is determined by adding all open contracts for which a buyer and a seller exist.
Importance of Open Interest
Market activity is gauged by open interest. There are either no available positions, or almost all of the posts have been filled if there is little to no open interest. High open interest indicates numerous unfilled contracts, which signifies that market participants will closely monitor that market.
A futures or options market's open interest is a gauge of the amount of money entering those markets. While declining open interest implies money leaving the market, increasing open interest shows new or more money entering it.
READ MORE: All you need to know about futures and options trading
Advantages of monitoring Open Interest
- Some inferences about the trading day's activity can be made by keeping an eye on the changes in the open interest data at the close of each trading day.
- Growing open interest indicates that new capital is entering the market. The current trend (up, down, or sideways) will therefore continue.
- The market liquidates when open interest declines, which suggests that the current price trend is ending. The conclusion of significant market changes can benefit from understanding open interest.
- A continuous price gain followed by a levelling down of open interest is frequently an early sign that an uptrend or bull market is ending.
We hope you now have a good understanding of what open interest is. Here is a word of warning now. Avoid entering the market if you notice numerous open positions and a large price movement. It is a sign that an unexplainable over-enthusiasm is gripping the market. Even a minor trigger is sufficient to send traders into a panic when it does. All of a sudden, everything will collapse if it does.