What is Open Interest?

Key Highlights

• The total number of active contracts that are not yet closed or resolved is known as open interest.

• Open interest will rise when a new buyer and seller sign a contract. It will decline if contracts are closed or executed. But open interest doesn't change when a new buyer and an old seller sign a contract.

• The open interest to volume ratio shows that open interest and volume are not the same. Open interest is a running tally of the active contracts. Whereas volume is the total number of contracts exchanged in a given time frame.

• To gain a deeper understanding of money movement in the stock market, traders and investors can utilise open interest along with other indicators such as price and trading volume.

Open Interest Meaning in Share Market

Open interest refers to the total number of open contracts market participants hold after a day. It can also be referred to as the overall number of futures or option contracts that still need to be executed, expired, or completed by delivery.

In particular, open interest applies to the futures market. Open interest, or the total number of open contracts on the security, is often used to confirm trend reversals in futures and options contracts. Money flows into the futures market are measured as open interest. There must be a buyer of that contract for each seller of a futures contract. Thus, only one contract is created by the seller and buyer.

Therefore, traders need only know the totals from one side or the other, buyers or sellers, not the sum of both, to determine the total open interest in any given market. The number of contracts on a day shall be shown as an increase or decrease in the open interest position, which is notified each day and will be presented positively or negatively.

How To Calculate Open Interest

Open interest is calculated for a specific derivative contract by summing up the total number of long and short buy and sell contracts. There are long-side buyers and short-side sellers in every futures or options contract. Open interest will increase when a new contract is entered into between the purchaser and the seller. Open interest shall be reduced by one when an existing contract is replaced by the seller's and buyer's closing of positions.

Using Open Interest For Trading

There are some key principles to use the open interest. The following table illustrates them.

Many experts believe that the trend will continue as long as there is a high level of bullish sentiment and more traders are opening new contracts the open interest will rise. Many also conclude that a trend is waning when the price rises and open interest falls. A declining open interest is a sign that traders are getting rid of their positions. Technical analysts deduce that a trend is weak when the price falls and the open interest value rises. Traders usually think that the particular trend is strengthening and will reverse when the price and open interest decline.

Working of Open Interest

Open interest is used to estimate the amount of money coming into or going out of a futures or options market. A rise in open interest indicates fresh money entering the market. Whereas a fall in open interest indicates money leaving the market. It provides information on an option's liquidity. So, it is very crucial for options traders.

Example of Open Interest

Consider an example of calculating open interest on futures contracts, the common area where open interest can be applied.

Example: Suppose you follow a futures contract for "XYZ" in the stock market. There are 100 shares of Stock XYZ for each futures contract.

Let us calculate the open interest for each day:

Day 1:

• The purchase of Trader A increases open interest by 5 contracts.
• 3 contracts have been taken off the open interest by Trader B's sale.
• Open interest on Day 1 is (5 - 3) = 2 contracts.

Day 2:

• The purchase of Trader C has resulted in 2 contracts being opened for interest.
• The sale by Trader A results in a reduction of 1 contract's outstanding interest.
• Open interest on Day 2 is (2 - 1) = 1 contract.

Day 3:

• 4 open interest contracts are added to Trader D's purchase.
• Open interest is multiplied by 2 contracts when Trader B buys to cover his short position.
• Open interest on Day 3 is (4 + 2) = 6 contracts.

So, the open interest for the stock XYZ futures contract is 2 contracts on Day 1, 1 on Day 2, and 6 on Day 3. An open interest is helpful for understanding the level of liquidity on the market. Greater open interest will make it easier to trade and exit at competitive bidding or asking rates, because the market is more liquid.

Open Interest and Volume

In the futures market, open interest and volume are two key ideas. Investors use both these indicators to forecast trends. They are some common aspects. However, OI and volume are not the same.

Open interest indicates the quantity of open contracts held by individual buyers and sellers in the futures market. In this market, a buyer should exist for each contract that is sold. Thus, the total number of contracts that are transacted during the day stays balanced. Volume is the total number of contracts that are completed in a given day. Thus, if one contract is purchased and sold, the volume increases by one.

The volume is set at zero when the day starts. As a result, you are able to see exactly how many contracts are traded during trading hours. Compared to volume, open interest is more easily visible. Depending on how many traders enter or leave the deal, the open interest value may or may not change.

Let's use an example to understand this better. Assume that A, B, and C are the three traders present in the market. Buyer A purchases all the 10 futures contracts that Seller B sells on the first day. Thus, following the first day, open interest and volume were both 10.

The next day, C purchases 7 contracts and A sells 7. When the second day ends, the volume changes to 7 (the number of contracts that were exchanged). However, open interest stays at 10 since the market did not produce any new contracts.

It is vital to remember that open interest may fluctuate for days, whereas volume varies every day. Until new contracts are started or the existing ones are settled or executed, open interest will stay the same.

Importance of Open Interest

Open interest is used to measure market activity. There are no openings, or nearly all positions are closed because of little or no open interest. High open interest means several contracts remain negotiated, and market participants will pay close attention to these markets.

Open interest refers to money flowing into or out of a futures or options market. It refers to new or additional money that comes into the market, while lower open interest indicates outflows from the market. Open interest is essential to options traders as it provides vital information on option liquidity.

Benefits of Monitoring Open Interest

Open interest has several benefits. You can monitor and know different changes in the stock market.

1. New funds flow to the market as open interest increases. This will lead to the continuation of the current upward, downward, or sideways trend.

2. The decrease in open interest shows the market's decline and indicates that the price trend has ended. In particular, open interest knowledge can be helpful in reaching the end of significant market movements.

3. After a prolonged price gain, a levelling off of open interest is frequently a sign that an uptrend or bull market is ending.

Tips to Use Open Interest to Gauge Market Performance

Open interest is a strong tool for reading market sentiment. A rising OI with increasing prices signals strong bullish trends, while a rising OI with falling prices indicates bearish strength.

A declining OI with rising prices may suggest short covering, whereas a falling OI with dropping prices points to long unwinding. Comparing OI with volume gives clarity as high OI and high volume confirm strong participation, while mismatches may indicate weak conviction.

Always track OI alongside price action and broader market trends. It is also prudent to avoid reading OI in isolation; combining it with technical analysis helps to improve accuracy in gauging market performance.

Conclusion

Open interest is the total number of open derivative contracts that have not yet been settled. They are still not used, finished, or run out. This measure is linked to the options and futures markets rather than the stock market. Instead of adding up all of the transactions between buyers and sellers, open interest is based on the total number of open contracts, and is typically not used as a trend or price movement indicator.