What is Open Interest in Options Trading?

In the options market, "open interest" refers to the total number of outstanding option contracts that are currently active and have not been settled or closed. As such, open interest provides insight into the liquidity and activity level of a particular option.

In contrast to open interest, “volume” represents the number of contracts traded in a given period, such as the daily trading volume. Ideally, both open interest and daily trading volume are robust, making it theoretically easier to open and close trades in this market.

Sudden changes in open interest can be an important market indicator. For example, open interest might spike if the underlying asset makes a significant move in one direction or the other. It may also increase suddenly due to rising expectations of a future event.

When open interest is low, it is often viewed as a potential red flag because trading in options with low open interest can contribute to an inefficient market. For example, an option with low open interest might have a wider bid-ask spread, making transactions more expensive. This inefficiency can lead to higher trading costs and increased difficulty in entering or exiting positions at favorable prices.

Open interest is a key concept in the options market, representing the number of options contracts held by all market participants in the form of active positions—positions that have been opened but have not yet been closed or otherwise settled (via expiration or exercise/assignment).

It should be noted that each type of option—calls and puts—tracks its own open interest independently. Call options give the holder the right to buy the underlying asset at a specified price, while put options give the holder the right to sell the underlying asset at a specified price.

The open interest for call options represents the total number of outstanding call contracts that are currently active and have not been settled or closed. Similarly, the open interest for put options represents the total number of outstanding put contracts that are active and not yet settled or closed.

Open interest changes on any given trading day, assuming there’s activity in that particular option. For example, when traders close out more positions than they open (net), then the open interest for that option will decrease.  

Conversely, the open interest indicator increases when traders open more new positions than the number of contracts they close. For example, if more contracts are initiated than settled, open interest goes up.

To illustrate, imagine the open interest for a particular call option in the underlying XYZ starts at 20. The next day, a trader buys 10 XYZ options contracts as new positions, thus increasing the open interest to 30. The following day, five XYZ contracts are closed, but 10 new contracts are opened. This results in a net increase of five, bringing the total open interest to 35.

As one can see, the open interest indicator provides valuable insight into market liquidity. By monitoring this indicator, market participants can therefore make more informed decisions when opening, closing, and risk-managing a given position. 

Open interest rises when the number of new options contracts created exceeds the number of contracts closed or settled on a given day. This increase occurs as traders open more new long positions (buyers) or new short positions (sellers) than those being closed. An increase in open interest can often indicate growing market activity and increased liquidity, reflecting heightened trader interest and participation in the options market.

Open interest falls when the number of options contracts closed or settled exceeds the number of new contracts created on a given day. This decrease occurs as traders close more long positions (buyers selling) or short positions (sellers buying back) than the number of new contracts being opened. A decline in open interest can indicate waning market activity and reduced liquidity, reflecting diminishing trader interest and participation in the options market.

Open interest is important because it provides valuable insights into the liquidity and activity levels in the options market, helping traders understand the depth and robustness of market participation. 

Open interest can be an indicator of market sentiment, with rising open interest often signaling increased trader interest in this particular option market, as well as the broader symbol. On the other hand, falling open interest is often associated with decreasing participation, and potentially declining interest in the option or symbol.

It should also be noted that increased anxiety in the financial markets can impact both daily trading volume and open interest in the options market. As investors and traders become more fearful, they often look to the options market for hedging purposes. Due to these dynamics, open interest and daily trading volume are viewed as valuable sources of information for participants in the options market.

By tracking open interest, traders can gauge the ease of entering and exiting positions, assess potential volatility, and better understand overall market dynamics, leading to more informed trading decisions.

For this example, consider a call option for XYZ that currently has 5,000 contracts of open interest. The following hypothetical example details how that open interest changes from one trading day to the next.

Open Interest, Day 1

Open Interest: 5,000

Open Interest, Day 2

On the second day, 1,000 new XYZ call option contracts are created. Meanwhile, 500 contracts are closed. The open interest increases by the net change, as outlined below:

• Initial Open Interest: 5,000

• New Contracts: +1,000

• Closed Contracts: -500

• Net Change: +500

• Updated Open Interest: 5,500

Open Interest, Day 3

On the third day, 1,000 contracts are closed and 700 new contracts are opened. The open interest decreases by the net change, as outlined below: 

• Initial Open Interest: 5,500

• New Contracts: +700

• Closed Contracts: -1,000

• Net Change: -300

• Updated Open Interest: 5,200

Open Interest, Day 4

On the fourth day, there is significant market activity due to an upcoming earnings report. Traders open 2,500 new contracts and close 1,000 existing contracts.The open interest increases by the net change, as outlined below:

• Initial Open Interest: 5,200

• New Contracts: +2,500

• Closed Contracts: -1,000

• Net Change: +1,500

• Updated Open Interest: 6,700

Open interest and trading volume are both key metrics in the options market, but they serve different purposes. Open interest represents the total number of outstanding options contracts that are currently active and have not been closed or otherwise settled (via expiration or exercise/assignment)

Trading volume, on the other hand, measures the number of contracts traded during a specific period (e.g daily volume), indicating the level of activity over that timeframe. 

While open interest shows the ongoing commitment of traders to their positions, trading volume reflects the immediacy of market activity during a given period. Together, these metrics provide important insights into the overall liquidity of a given option. 

The question of whether higher open interest is good depends on the context. Generally, higher open interest is considered a positive sign because it indicates greater market participation and liquidity, which can contribute to a more efficient market. This can be beneficial as it can help reduce transaction costs (via a tighter bid-ask spread) and potentially make it easier to enter and exit positions.

However, open interest isn't the only determinant of adequate liquidity; trading volume is another important indicator. Market participants in the options market should ensure that a particular option fits their overall requirements before establishing a position. For example, by ensuring robust open interest and daily trading volume, as well as any other factors they may deem critical. 

When open interest increases, it indicates that more new options contracts are being created than closed, suggesting increased market participation and liquidity. Conversely, when open interest decreases, it means more contracts are being closed or settled than opened, indicating reduced market participation and liquidity.