Understand Open Interest: Definition, Examples and Importance

What is Open Interest?

Futures traders often determine their trading strategies depending on the open interest in the market. If you are a beginner in futures trading, educating yourself on open interest (OI) is critical. It is also important to understand that open interest is not volume. We will discuss open interest vs. trading volume in later sections. 

Open interest marks the total number of outstanding futures/options contracts held by market participants at the end of a trading day. It is an indicator used by traders to evaluate market sentiment and the strength behind the price trend. Simple definition, right? 

Unlike the number of shares issued by a company, which remains constant, open interest changes daily depending on the number of new contracts available for trading or settlement. The open interest shows the number of contracts that were not settled at the end of the trading session. It tracks the total number of contracts opened for an underlying asset and, therefore, presents a more accurate estimation of the contract’s liquidity and interest. It provides clarity on whether the money flowing into the contract is increasing or decreasing. 

Example of Open Interest

When you are buying or selling futures, you are either opening or closing an interest. If you buy 10 contracts of XYZ stock, the purchase opens a position. Therefore, your trade increases opening interest by 10. Now, if you close your position by selling those 10 contracts, the open interest in the market falls by 10. 

Here is a detailed illustration of a real-life situation:

Let’s assume there are 5 traders trading futures in the market. They are A, B, C, D, and E. At the beginning of the week on Monday, A bought 5 contracts and B bought 5 contracts, while trader C sold all 10 contracts. So, after day 1, the open interest table will look like the one below. 

Day 1’s trade is summarised in the table below:

Note: Here L represents long or buying and S represents short or selling.

Day 2: 

On Tuesday, trader D enters the market. Trader C wanted to get rid of 7 of the 10 contracts, and she sold those to trader D. Although a transaction happened, there were no new contracts created.  

Day 3: 

Trader D wants to increase his holding position and buys 7 more short positions. At the same time, traders A and B also want to increase their long positions. So, D sold 2 contracts to A and 2 to B. Trade C. wants to close her position by going long on 3 contracts, so she transfers her 3S contracts to D. 

At the end of the 3rd day trading, the total open positions were 14. 

Day 4: On Day 4, another trader E enters the market and wants to sell 20 contracts. Trader D wanted to liquidate his position, so he bought 14 contracts from E and transferred 14 contracts to E. Finally, trader A bought 4 contracts from E, and the remaining 2 were bought by B.

As you can notice, the open interest position has changed, and it has now changed to 20 This process continues as new and old traders change their positions. This example will help you understand how open positions get altered and how many open positions are available in the market.

Open Interest vs. Trading Volume 

Trading volume refers to all transactions happening during the day. The total volume is the aggregate of all the trading that happened in a trading session. Daily trading volume gives you clarity about the strength of the current price movement, including investor demand and liquidity.

However, the transfer of these contracts doesn’t create new positions in the market, hence, it will not give you an idea of how many open positions are available. 

The Importance of Open Interest 

An open position measures the flow of money. If open positions are increasing, it means more money is coming into the market. Conversely, if the number of open positions is decreasing, it signifies a cash outflow. A high open position is an indication that lots of contracts are open and participants are watching the market closely.

Moreover, it serves as an indicator of market sentiment, revealing the collective opinion of market participants about the future direction of an asset. Rising open interest suggests increasing interest among participants and the possibility of a potential new trend, whereas declining open positions indicate a weakening trend.

Final Words 

Open interest refers to the number of derivative contracts that are not settled, closed, or expired. It serves as a valuable window into the dynamics of futures and options markets. It offers insights into market sentiment, trend strength, and potential reversals. By taking open interest into consideration, you can make more informed decisions.

FAQs